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Probabilities and replication principle

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Consider a model with only one time period. Assume that there exist a stock and a cash bond in the model. The initial price of the stock is $40. The investor believes that with probability 1/5 the stock price will drop to $20 and with probability 4/5 the stock price will rise to $80 at the end of the time period. The cash bond has an initial price of $100 and it will with certainty deliver $110 at the end of the period. Does this model admit any arbitrage opportunities? Explain your answer. Find a price of a European Put option with a maturity at the end of the time period and a strike price of $60 using risk neutral probabilities and replication principle. Comment on the equivalence of the two approaches.

Reference no: EM133082455

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