CFA Level I · CFA Level I Exam · Pricing and Valuation of Options
In a one-period binomial model, an investor creates a riskless hedge by buying shares and selling one call option. Holding the other inputs constant, the number of shares needed per call, the hedge ratio, is most likely to:
The hedge ratio rises as the call moves deeper in the money. It is the difference in option payoffs divided by the difference in underlying prices, and for a deep in-the-money call it approaches one share per option.
- Arise when the call is deeper in the moneyCorrect
- Bfall when the call is deeper in the money
- Cbe unaffected by the strike price
Explanation
The hedge ratio equals (call up payoff − call down payoff)/(S up − S down). When the call is deeper in the money, the option payoffs in the two states differ more as a share of the underlying spread, so the ratio rises toward 1. It depends on the strike, so the third option is wrong.
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