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A stock price is currently $40. During each two-month period for the next four months it is expected to increase by 10% or decrease by
A stock price is currently $40. During each two-month period for the next four months it is expected to increase by 10% or decrease by 8%. The risk-free interest rate is 5%. Use a two-step tree to calculate the value of a derivative that pays off (max[(Sr-35),0])? where S, is the stock price in four months. a. Use no-arbitrage arguments (you need to show how to set up the riskless portfolios at the different nodes of the binomial tree). b. Use risk-neutral valuation. c. Verify whether both approaches lead to the same result. d. If the derivative is of American style, should it be exercised early
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