Q17
I don’t get why the payoffs at expiration from portfolio of long stock and short bond in down state = 42.5-42.5 =0, and up state is 56-42.5=13.5.
I also do not get why to avoid arbitrage, for each share of stock bought one should sell 13.5/11 calls or for each call sold one should buy 11/13.5 stocks.
Can you please explain this to me better than the textbook. THank you!
The question can be answered intuitively in 10 seconds, but the answer rather complicates the methodology. We will need the call-put parity here. Synthetic call = p + s - bond. Since the call is overvalued (7.75 vs 7.44) we short call and long p, s and short bond. By looking at answer choices only A and B are candidates. Also remember in delta hedging we need more calls than shares (calls=shares/Δ, and delta is usually smaller than 1), so immediately you can choose answer A. Now back to your issues. I hope the diagram helps.