Problem 2

Find the value of a European put option using the binomial option pricing model. The parameters are S = 62, X = 70, r = 0.08, u = 1.10, and d = 0.95. There are no dividends. Use n = 2 periods. (You can borrow any additional funds required at the risk-free rate, and any excess funds should be invested at the risk-free rate.)

A. Find the value of stock at time-period 1, and time-period 2

B. Find the value of the put at time-period 0, time-period 1 and time-period 2

C. Find the hedge ratio at time-period 0 and time-period 1

D. Find the value of hedge portfolio at time-period 0, time-period 1 and time-period 2. Show

that no arbitrage exists. Also make any necessary changes to the hedge portfolio based on

the adjustment to the hedge ratio.

E. What will be your strategy if the call is overpriced and underpriced?