Microsoft PowerPoint - PoF.ppt

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The replicating portfolioƒ 208

The replication argument depe

nds on several assumptions:

ƒ

Short positions are allowed

(unlimited credit).

ƒ

Shares of stock can be subdivided

for sale or purchase.

Essentially satisfied because option

pricing and hedging (replication)

typically involve lots of options.
ƒ

The interest rate for investing is

the same as the interest rate for

borrowing

; we use a constant risk-free rate which is assumed to be the

same for all maturities.Is close to being true for large institutions.
ƒ

The purchase price of stock is the same as the selling price

, i.e.

there is zero bid-ask spread.Is not satisfied in practice.
ƒ

No transaction costs, taxes, ...
ƒ

At any time,

the stock can take only two

possible values in the next

period.In the Black-Scholes model, this assump

tion is replaced by the assumption

that the stock price is a geometric Brownian motion. Empirical studies of stock price returns have consistently

shown this not to be the case!

Derivative securities: Options - Binomial asset pricing model

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