The current price of XL Corporation stock is $40.  In each of the next two years, this stock price can either go up by $15.00 or go down by $15.00.  XL stock pays no dividends.  The one-year risk-free interest rate is 15% and will remain constant. Using the binomial pricing model, calculate the price of a two-year American straddle option on XL stock with a strike price of $40.

Question
Asked Nov 5, 2019
6 views

The current price of XL Corporation stock is $40.  In each of the next two years, this stock price can either go up by $15.00 or go down by $15.00.  XL stock pays no dividends.  The one-year risk-free interest rate is 15% and will remain constant.

 

Using the binomial pricing model, calculate the price of a two-year American straddle option on XL stock with a strike price of $40.

check_circle

Expert Answer

Step 1

Calculate the probabilities:

p is 57.37% and 1-p is 42.63%.

help_outline

Image Transcriptionclose

S55 ($40+S15) P $40 1-P $35 ($40-S15) (555x(P)+(S35x (1-P) =(s40x (e15 $55P $35-$35P = $46.4733 65 11.473365 P = 20 =0.573668 or57.3 7% 1-P [1-57.37% =42.63%

fullscreen
Step 2

Create a binomial model:

help_outline

Image Transcriptionclose

$70 ($40+$15+$15) $55 ($40+$15) Stock Price $40 Strike Price = $40 $40 ($40+$15-$15) $35 ($40-$15) $20 ($35-$15)

fullscreen
Step 3

Calculate the Price of the Option:

Note that 2.71828 denotes the numerical value of exponential (e).

Excel Spreadsheet:

...
help_outline

Image Transcriptionclose

B 1Strike Price 2 Probability 3 1-Probability 4 Payoff at $40 5 Payoff at $20 6 Riskfree Rate 7 Price of Option $40 57.37% 42.63% $0 $20 15% $2.8738

fullscreen

Want to see the full answer?

See Solution

Check out a sample Q&A here.

Want to see this answer and more?

Solutions are written by subject experts who are available 24/7. Questions are typically answered within 1 hour.*

See Solution
*Response times may vary by subject and question.
Tagged in

Business

Finance

Related Finance Q&A

Find answers to questions asked by student like you
Show more Q&A
add
question_answer

Q: AXYZ Co's. bond has a $1,000 face value and a coupon rate of 6.2% paid annually. The firm's marginal...

A: Calculation of cost of debt after tax:Answer:Cost of debt after-tax rate is 4.03% and 4.65%, tax cut...

question_answer

Q: You purchase a home and secure a 30 year equal payment loan for $200,000 at a interest rate of 5.25%...

A: The number of months to stay will be around 6 months.

question_answer

Q: what is a provable intrinsic value? can you give a example

A: Intrinsic value of a stock is its fundamental value. This is calculated by taking in to consideratio...

question_answer

Q: The Brandon household has monthly income of %5,630 on which to base their budget. They plan to save ...

A: Monthly budget is calculated on the base income of $5,630According to the information provided.Month...

question_answer

Q: A equal principal payment loan of $3000 is amortized by means of 12 quarterly payments, beggining on...

A: Loan Amount = $3,000Total Number of Payments = 12Loan Principal Payment = $3,000 ÷ 12 = $250Interest...

question_answer

Q: Explain the disadvantages and dangers of Home Equity Loans.

A: The disadvantages of home equity loans:Higher rate of interest: The interest rates are typically hig...

question_answer

Q: A corporate bond matures in 14 years.  The bond has an 8% semiannual coupon and a par value of $1,00...

A: Calculate the yield to maturity as follows:MS-Excel --> Formulas --> Financials --> Rate 

question_answer

Q: MMS Corp borrows $1,650,000 today for a new building. The loan is an equal principal payment loan wi...

A: Computation of payment due amount:Hence, the due amount is $20,219.95 or $20,220.

question_answer

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

A: As a management trainee, the answer for the CFO question will be that it is not easy to identify a d...