A stock price is currently $60. Over each of the next two six-month periods, it will either increase by 14% or decrease by 11%. The risk-free interest rate is 5% per annum with continuous compounding.

1) To use the 2-step binomial tree model to calculate a option price on the stock, calculate p (the risk-neutral probability) for each step (a six-month period).

Answer:

2) What is the value of a one-year European call option with a strike price of $60? Use no-arbitrage arguments

3) What is the value of a one-year American put option with a strike price of $62? Use no-arbitrage arguments and the two-step binomial model.