Question
Consider a one-period (one year) binomial model in which the underlying asset is at 65 and can go up 30 percent or down by 22
Consider a one-period (one year) binomial model in which the underlying asset is at 65 and can go up 30 percent or down by 22 percent (with 70% probability of going up and 30% probability of going down). The annual risk-free rate is null percent and striking price is 70. (a) (i) Determine the price of a European call option explain your method and detail the procedure. (ii) Assume that the call is selling for 8 in the market. Demonstrate how to execute an arbitrage strategy and calculate the rate of return. Use 10,000 call options. (8%) (b) What is the call price if you are using a two-period (each period is still a year and hence the call lasts two years) binomial model to price the option? Explain the reason of changes in call prices. (7%) (c) Consider the underlying asset follows a 1 period (one-year) random walk with expected return of 20.0%, either via different probabilities of going up/going down or via greater percentages of going up/going down. Explain how such information would affect the fair price of the European call option in part (a)
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