Consider a two period binomial model where in each round the stock increases or
ID: 2757072 • Letter: C
Question
Consider a two period binomial model where in each round the stock increases or decreases by 10%. The current stock price is $20 and the risk free rate is 3.33% each period. We first consider a European call option with a strike $20
a) Calculate the value of the option based on replication. Specify what will be the replicating portfolio in each round.
b) Calculate the value of the option based on risk-neutral probabilities
c) In this part we are interested in an option on option. Specifically, consider a European call option on the original option that lets you buy it to buy the option at a price of $1 at t=1. What is the fair market value for this option
PLZ GIVE EXPLANATIONS REGARDING CALCULATIONS OF EACH PART I.E OFFER EXPLANATION ON HOW YOU CAME TO THAT ANSWER (IN EACH PART)
Explanation / Answer
Ans2 Price Strike Price Premium Probablilty Option S1 $22 $20 $2 0.67 $1.34 S2 $18 $20 0 0.33 $0.00 Value of Option=$1.34/.0333 40.24024024 Probability1= CMP(1+r)-S2/S1-S2 $20(1+.033)-18/22-18 2.66/4 0.6650