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Problem Set 2: Binomial Option Pricing: Multiple Periods - European and American Option

This document contains two problems related to pricing options using binomial option pricing models. Problem 1 involves constructing a two-period binomial tree to price European and American call and put options on a stock with given parameters. It also involves calculating the replicating portfolio and cash flows from writing a European call option. Problem 2 involves pricing a 1-year European and American call option on a futures contract using given parameters in a binomial tree model, and calculating the difference between the American and European call option prices. The document provides the necessary information to solve these two problems.

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109 views

Problem Set 2: Binomial Option Pricing: Multiple Periods - European and American Option

This document contains two problems related to pricing options using binomial option pricing models. Problem 1 involves constructing a two-period binomial tree to price European and American call and put options on a stock with given parameters. It also involves calculating the replicating portfolio and cash flows from writing a European call option. Problem 2 involves pricing a 1-year European and American call option on a futures contract using given parameters in a binomial tree model, and calculating the difference between the American and European call option prices. The document provides the necessary information to solve these two problems.

Uploaded by

sadkind
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Prof.

PIRIM
Fall 2014, Session II
Options and Futures II (BusFin 4232)

Problem Set 2: Binomial Option Pricing: Multiple Periods-


European and American Option

This problem set is due at the beginning of class on Thursday, November 13th, 2014.
Hand in only one solution per group.

Question 1 (10 Points)

Let S=$40, K=$40, =30%, risk-free interest rate, r=8% (continuously compounding),
and T=0.5 year, and n=2, two-period binomial tree.

a) Construct the binomial tree for the stock. What are u and d values?
b) Compute the prices of American and European calls.
c) Compute the prices of American and European puts.
d) At time 0, now, assume you write the European call option and form the
replicating portfolio to offset the written option. Lets assume that market price of
this call option that you have written is $5. What is the replicating portfolio and
what are the net cash flow from selling the call option and buying the synthetic
equivalent?

Question 2 (15 Points)


You are to price options on a futures contract. A binomial tree models the movements of
the futures price. You are given the following information:
- Each period is 6 months, h=6months,
- Time to maturity of an option, T=1 year
- u/d=4/3, where u is 1 plus the rate of gain on the futures price if it is goes up, and
d is 1 plus the rate of loss if it goes down.
- The risk-neutral probability of an up move, p*=1/3.
- The initial futures price is $80.
- The continuously compounded risk-free interest rate is 5%.
- Let CE be the price of a 1-year 85-strike European Call option on the futures
contract, and CA be the price of an otherwise identical American call option on
futures contract.



Determine the difference between two prices; CA - CE

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