Which of the Following Is an INCORRECT Step in Pricing

question 3

Multiple Choice

Which of the following is an INCORRECT step in pricing an option by the no-arbitrage principle in a single-period binomial framework?

• A) We consider a market where a stock,a money market account,and an option trade.
• B) The stock can take one of two possible values at the expiration date and so does the option.
• C) We create a portfolio of the stock and money market account to replicate an option's payoff.
• D) We choose the portfolio of the stock and money market account to have the same value as the option today.Then,to prevent arbitrage,this "synthetic option" and the market-traded option must have the same payoffs on the option's expiration date.
• E) A portfolio holding the market-quoted option and the synthetic option on opposite sides of the market are free from price risk.This demonstrates that while solving the pricing problem,we also learn how to hedge the exposure.

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