Consider a stock currently priced at $150. In the next period, the stock can either increase by 33 percent or decrease by 15 percent. Assume a European put option with an exercise price of $150 and the risk-free rate of 4.5 percent. Suppose the call option is currently trading at $11. Assume that you can long and short US Treasury securities (equivalently, you can lend and borrow money at the risk-free interest rate). Also, the stock does not pay any dividend over the life of the option.

1) (10pts) Use a one period binomial model to calculate the price of the put option (X=150). You may solve this problem by completing the cells in gray.

2) (25pts) Is it currently overpriced, underpriced, or correctly priced in the market? If mispriced, calculate the hedge ratio (5pts), tell how to execute an arbitrage trading stategy (5pts), demonstrate (tabulate all trading transactions as discussed in class) how to implement the starategy (10pts), and clealy indicate the amount of risk-free profit (5pts). Use 1,000 put options (i.e., two contracts).

4.50% risk-free rate Size of an up-move, u Size of a down-move, d Current stock price, So 150 risk-neutral probability of up-move, Tu risk-neutral probability of down-move, d Exercise Price 150 Su So Po Pd Current market price of the put option Hedge ratio # of stock shares needed for the hedge