a. Computethe price of a European call option using the two period binomial model assuming

the following data:

S

0

= 10, T = 2 months, u = 1.5, d = 0.5, r = 0.05, K = 7, D=0

.

b.If the call option were selling at $4

, what would you do to create riskless arbitrage strategy?

Explain how the strategy is maintained over the two binomial periods assuming the

underlying asset price

declines in the first period

. Construct a table to demonstrate the exact

strategy and the cashflows from the strategy.

c.Now suppose the option is American. Verify that early exercise of the American call is not

optimal.

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