Binomial Model and Option Pricing

The shares of XYZ Inc. are currently selling for $120 per share. The shares are expected to go up by 10 percent or down by 5 percent in each of the following two months (Month 1 and Month 2). XYZ Inc. is also expected to pay a dividend yield of 2 percent at the end of Month 1. The risk-free rate is 0.5 percent per month.

a. What is the value of an American call option on XYZ shares, with an exercise price of $125 and two months to expiration? Use the binomial model to obtain the answer.

b. Draw a binomial tree diagram for this American call option, showing the share price, call price, and whether the call should be exercised at each state during the next two months.