Consider a one year American call option on 100 ounces of gold with a strike of

Question

Consider a one year American call option on 100 ounces of gold with a strike of $1200 per ounce. The spot price per ounce of gold is $1210 and the annual financing rate is 4% on a continuously compounded basis. Finally, gold annual volatility is 25%.    Assume no storage costs and a zero lease rate on gold. In answering the questions below use a binomial tree with two steps.

Value the option at time 0 using the binomial tree.

How would you hedge a short position in the call option at time 0 with a portfolio composed of a position in gold, and a cash borrowing or lending position?

Explanation / Answer

Consider a one year American call option on 100 ounces of gold with a strike of

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