Answer: Going long the underlying and borrow cash

## Explanation In the binomial option pricing framework, we can replicate option payoffs using the underlying asset and risk-free borrowing/lending. **For a short call option:** - Payoff = -max(S-K, 0) - When S > K: Payoff = -(S-K) = K-S - When S ≤ K: Payoff = 0 **Replication strategy:** To replicate a short call position, we need a strategy that: - Has negative exposure to the stock when S > K - Has zero exposure when S ≤ K This is achieved by: **Going long the underlying and borrowing cash** (Option A) **Why this works:** - When you go long the stock, you have positive delta - When you borrow cash, you create a fixed liability - The combination creates a position that behaves like a short call: - If stock rises above strike, your long stock position gains value but is offset by the fixed borrowing cost - The net position has limited upside (like a short call) **Mathematically:** The replication requires Δ shares of stock and borrowing B dollars: \[ \Delta = \frac{C⁺ - C⁻}{S⁺ - S⁻} \] \[ B = \frac{C⁻ - \Delta \times S⁻}{1+r} \] For a short call, the signs would be reversed, resulting in going long the underlying and borrowing cash.

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