The DerivaGem Application Buider functions enable you to investigate how the prices of options calculated from a binomial tree converge to the correct value as the number of time steps increases. (See Figure 17.4 and Sample Application A in DerivaGem.) Consider a put option on a stock index where the index level is 900, the strike price is 900, the risk-free rate is 5%, the dividend yield is 2%, and the time to maturity is 2 years.

(a) Produce results similar to Sample Application A on convergence for the situation where the option is European and the volatility of the index is 20%.

(b) Produce results similar to Sample Application A on convergence for the situation where the option is American and the volatility of the index is 20%.

(c) Produce a chart showing the pricing of the American option when the volatility is 20% as a function of the number of time steps when the control variate technique is used.

(d) Suppose that the price of the American option in the market is 85.0. Produce a chart showing the implied volatility estimate as a function of the number of time steps.

AppendixLO1