Call (it is the option which gives the owner of the option the right to buy)
Price as of today ( is c
In case the call option has the strike price of  , then the strategy at time  is as follows
Strategy at t=0 |
Inflow at t=0 |
Outflow at t=1 if S=25 |
Outflow at t=1 if S=100 |
Write 3 calls |
+3c |
0 |
-150 |
Buy 2 share of stock |
-100 |
+50 |
+200 |
Borrow 40 |
+40 |
-50 |
-50 |
Net flow |
(+3c-100+40) |
0 |
0 |
|
If we look carefully then we note that to avoid arbitrage we should have  , such that  .
The main problem is how do we incorporate the model so that we have one stock (Figure 10.1), plus one bond (Figure 10.2). This is the question we try to answer through the simple illustrations of Figures 10.3 &10.4 |
