Assume that the stock of Alitor Craft, Inc., is currently trading for $19 and will either rise to $21 or fall to $15 in one year. The risk-free rate for one year is 12 percent. What is the value of a call option with a strike price of $16? (Do not round intermediate computations. Round final answer to two decimal places.)

Question

Quizplus · Accepted Answer

To calculate the value of the call option, we need to determine the probability-weighted expected return of the stock.

The probability that the stock will rise to $21 is 0.5 (50%), and the probability that it will fall to $15 is also 0.5 (50%).

Using these probabilities, the expected return is:

Expected return = (0.5 * $21) + (0.5 * $15) = $18

To calculate the value of the call option, we need to subtract the strike price from the expected return and discount the result back to present value using the risk-free rate.

Value of the call option = e^(-rt) * (Expected return - Strike price)
                     = e^(-0.12*1) * ($18 - $16)
                     = $4.67

Therefore, the best choice is A as it is the calculated answer.

Assume That the Stock of Alitor Craft, Inc