INTRODUCTION TO ARBITRAGE PRICING OF FINANCIAL DERIVATIVES

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INTRODUCTION TO ARBITRAGE PRICING OF FINANCIAL DERIVATIVES

that is {{g(ST ) =½ST ¡ K if ST > K (option is exercised),0 if ST · K (option is abandoned).}} In fact, if at the expiry date T the stock price is lower than the strike price, the holder of the call option can purchase an underlying stock directly on a spot (i.e., cash) market, paying less than K: In other words, it would be irrational to exercise the option, at least for an investor who prefers more wealth to less. On the other hand, if at the expiry date the stock price is greater than K; an investor should exercise his right to buy the underlying stock at the strike price K: Indeed, by selling the stock immediately at the spot market, the holder of the call option is able to realize an instantaneous net pro….

 

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