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Option Pricing -- Risk-free Portfolio
Although replicating portfolio and risk neutral approach provide elegant solutions to option pricing, they require strong assumptions which are not realistic. In real business world, people rely on risk-free portfolio approach to valuation options. By creating risk-portfolio including the options to be priced, risk-free rate can be applied confidently.
Suppose you want to price a call option on WWW Inc. The current stock price of WWW is $60. The risk-free rate is 3%. What is the appropriate price of the 1 year call option of WWW Inc. with a strike price of $58 using risk-free portfolio approach? You project the stock price of WWW will either be $54 or $64 in a year.
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