When the returns of an option and stock are perfectly correlated as in a two-state binomial option model, the hedge ratio must be equal to the ratio of ________.
A) the range of the option outcomes to the range of the stock outcomes
B) the range of the stock outcomes to the range of the option outcomes
C) the standard deviation of the option returns to the standard deviation of the stock returns
D) the standard deviation of the stock returns to the standard deviation of the option returns

Question

Quizplus · Accepted Answer

The hedge ratio in a two-state binomial option model, where the returns of an option and stock are perfectly correlated, is determined by the ratio of the range of the option outcomes to the range of the stock outcomes. This ratio helps in creating a perfectly hedged portfolio by indicating how much of the stock should be bought or sold for each option.

When the Returns of an Option and Stock Are Perfectly