CFA Mock PM:
I guessed for the below question. I have been staring at this for the past hour and cannot understand the logic behind it. Could someone explain??
Exhibit 1
Binomial Model Variables
u
1.15
d
0.90
π
0.52
Index price
EUR 720
Strike price
EUR 750
Hedge ratio
.5697
1-Year interest rate
3%
S-
648
C-
0
Messer explains, “Of course, with the index moving down 10% in the last 12 months, the payoffs with these options could have been replicated without using options.” Szillat responds, “My understanding is that the payoff would have been the same as the call option if you had purchased 0.5697 index units and lent EUR 356.79 at the one-year interest rate.”
With respect to his assessment of replicating the option payoff, Szillat is least likely correct about:
purchasing 0.5697 index units.
using the one-year interest rate.
lending EUR 356.79.
Correct.
Szillat is incorrect in his method of replicating the call option. It can be replicated by purchasing the amount of the underlying shares designated by the hedge ratio and then borrowing (not lending) an amount equal to the present value of (hedge ratio × S- + C-) or
(1 ÷ 1.03) × ((.5671 × 648) + 0) = 356.79.