A corporate treasurer is contemplating buying a five-month down-and-out put option on the Australian dollar with an exercise price equal to the current spot rate of the Australian dollar of USD0.7200 and a barrier at USD0.6000. Her treasury analyst estimates that the Australian dollar will either rise or fall by 5% during each onemonth period. The term structure is flat in both Australia and the US, with risk free rates of 1.5% and 0.5% p.a. respectively, continuously compounded.

Required

(a) Build a five-period binomial model to price the down-and-out put option. Make sure you include a binomial tree diagram for the exchange rate.

(b) Compare the price of the down-and-out put option with that of a standard European put option priced using a five-period binomial model. Account for the difference in price.