Question
At the time of writing, the share price of CAR is $18.86. Assume this is time zero. You wish to compare premium prices of a
At the time of writing, the share price of CAR is $18.86. Assume this is time zero. You wish to compare premium prices of a European call calculated with the BlackScholes model, with premium prices calculated with a binomial model. The call has strike price K = $20, and expires in 90 days so T = 90/365 years. The yearly volatility of CAR shares is estimated to be = 2.55 . Assume the continuously compounding interest rate is r = 3% pa. (a) Calculate the call premium using the Black-Scholes model. (b) Consider a three-step binomial CRR model. (i) Assuming interest rates are constant over the life of the call, calculate the return R over one time step. (ii) Calculate the up and down factors u and d in this three-step model. (iii) Calculate the risk neutral probability in this three-step model. (iv) Construct a three-step binomial pricing tree for the call and calculate its premium. (c) Consider a six-step binomial CRR model. (i) Assuming interest rates are constant over the life of the call, calculate the return R over one time step. (ii) Calculate the up and down factors u and d in this six-step model. (iii) Calculate the risk neutral probability in this six-step model. (iv) Construct a six-step binomial pricing tree for the call and calculate its premium. (d) Compare the premiums calculated with the three-step and six-step binomial models with the premium calculated with the Black-Scholes model. You should find that the premium calculated from the six-step model is closer to the Black-Scholes solution than the premium calculated from the three-step model. Why?
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