hello
please may I ask for some help with S2008 Q7 P(ii) a - valuation using a risk neutral portfolio :
Q7
"Consider a one-period Binomial model of a stock whose current price is 0 S = 40 . Suppose that:
• over a single period, the stock price can either move up to 60 or down to 30
• the continuously compounded risk-free rate is r = 5% per period
(ii) Calculate the price of a European call option with maturity date in one period and strike price K = 45 using each of the following methods:
(a) by constructing a risk-neutral portfolio"
Specifically the published solution with respect to valuing the option using a risk neutral portfolio states:
"First method: we construct a risk-neutral portfolio with 1 underlying asset and m call options. We choose the value of m such that this portfolio is risk neutral (its value in the upper state and in the lower state at time 1 should coincide). In this case, m = −2"
Can someone please help me understand what "value in the upper state and in the lower state at time 1 should coincide" means in the context of risk neutral
Any help would be appreciated. Pardon any lapse in decorum this is my first post.
Last edited by a moderator: Sep 3, 2020