a). Suppose the price of a stock today is 100. The strike prices of call and put options trading on the stock are 120. These options mature in 24 months. The discount risk-free rate is 6% per annum. The risk-neutral binomial analysis with a time step of 12 months of a European call option produces an option value of 20.73. The downward factor for the lattice model of the stock-price process is 0.670. Identify 1) the risk-neutral probabilities of the binomial tree and 2) the annualized variance of stock returns. (16 marks)

b) Assuming the standard option inputs (stock price, riskless rate, maturity, strike and volatility) above are unchanged, what behavioural factors would justify a binomial option value of 15.18 for the call option? Explain. (15 marks)