Question 1. Consider a two-step binomial tree, where a stock that pays no dividends has current price 100, and at each time step can increase by 20% or decrease by 10%. The possible values at times T = 2 are thus 144, 108 and 81. The annually compounded interest rate is 10%. a) Calculate the price of a two-year 106-strike European put using risk-neutral probabilities. b) Calculate the price of a two-year 106-strike European put using replication. c) Calculate the price of a two-year 106-strike American put using replication, and hence verify that the American put has price strictly greater than the European. d) Calculate the prices of a two-year 86-strike European put and American put. What is different from part (c)?

Question

Question 1. Consider a two-step binomial tree, where a stock that pays no dividends has current price 100, and at each time step can increase by 20% or decrease by 10%. The possible values at times T = 2 are thus 144, 108 and 81. The annually compounded interest rate is 10%.

a) Calculate the price of a two-year 106-strike European put using risk-neutral probabilities.

b) Calculate the price of a two-year 106-strike European put using replication.

c) Calculate the price of a two-year 106-strike American put using replication, and hence verify that the American put has price strictly greater than the European.

d) Calculate the prices of a two-year 86-strike European put and American put. What is different from part (c)?

Expert Answer

Want to see the step-by-step answer?

Check out a sample Q&A here.

Want to see this answer and more?

Experts are waiting 24/7 to provide step-by-step solutions in as fast as 30 minutes!*

*Response times vary by subject and question complexity. Median response time is 34 minutes and may be longer for new subjects.
Tagged in
BusinessFinance

Derivative Markets

Related Finance Q&A

Find answers to questions asked by students like you.

Q: XYZ company has just paid a dividend of $1.15. The required rate of return on the stock is 13.4%, an...

A: Dividend = $1.15Growth Rate = 8% or 0.08Required Rate of Return = 13.4% or 0.134 Calculation of Curr...

Q: Suppose that JB Cos. has a capital structure of 78 percent equity, 22 percent debt, and that its bef...

A: WACC refers to a firm's weighted average cost of capital. It is the rate that a firm  pays to its se...

Q: Taggart Transcontinental and Phoenix-Durango have entered into a stock swap merger agreement whereby...

A: Company T’s premerger price is $15 whereas Company PD’s is $30. Company T needs to pay a 30% premium...

Q: You are a management trainee in one of the Manufacturing companies based in Johor, Malaysia. The com...

A: Value of the firm:Value of the firm is measured by using sum of value of firm’s equity and its debt....

Q: You own a furniture manufacturing company. You are looking to expand into glass furniture and need t...

A: 1. a) Calculation of ARR: The ARR for Machine 1 is 28.89% and Machine 2 is 32.73%. Excel Spreadsheet...

Q: ASDF Corporate Income Statement Current Year Units Sold 100,000 $37.84 $3, 784,000 $1,284,000 Unit P...

A: Hence, Combined leverage has a degree of 1.28, which is determined by dividing the difference of sal...

Q: What is the present value of an investment that will pay $1,000 in one year's time, and $1,000 every...

A: Calculation of Present value of perpetuity:Answer:The present value of the investment is $12,500

Q: Kassidy's Kabob House has preferred stock outstanding that pays a dividend of $5 at the end of each ...

A: Preferred Stock Dividend = $5Preferred Stock Price = $50 Calculation of Required Rate of Return per ...

Q: Consider the following annual returns of Molson Coors and International Paper:    MolsonCoors Int...

A: With the given values we first need to determine the average returns and then standard deviation and...