A. A non-dividend-paying stock has a current price of 800 ngwee. In any unit of time

(t, t + 1) the price of the stock either increases by 25% or decreases by 20%. K1 held in cash between times t and t + 1 receives interest to become K1.04 at time t + 1. The stock price after t time units is denoted by St.

Required:

I. Calculate the risk-neutral probability measure for the model. (5 marks)

II. Calculate the price (at t = 0) of a derivative contract written on the stock with expiry date t = 2 which pays 1,000 ngwee if and only if S2 is not 800 ngwee (and otherwise pays 0). (10 marks)

B. Suppose you are a market-maker in the LUSE Index forward contracts. The LUSE Index spot price is K550 and the annual risk free rate is 5%.

Required:

I. Calculate the forward price for delivery in 9 months. (3 marks)

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II. If the actual forward price is K561, how can you take advantage on this situation? (4 marks)

III. What are the problems that you will face in taking advantage of the situation?