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Problem 3. (10 points) A broker writes a long call ladder spread with expiry date T = 2 months and payoff function ST 120 Payoff

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Problem 3. (10 points) A broker writes a long call ladder spread with expiry date T = 2 months and payoff function ST 120 Payoff VI 0 ST 80 20 140 - ST The risk-free interest rate is r = 0.02 and the initial price of the underlying So = 90. (a) Compute the fair price of the spread using a 2-level tree model with St = 1, u = 1.2 and d = 0.85. For simplicity, the prices of the underlying are given below. S2 = 129.6 Si 108 So = 90 S2 = 96 Si = 76.5 S2 = 65.025 (b) Consider the price path up-up and describe the cash flow of the corresponding delta-hedging procedure for the broker selling this option. You may fill the chart below, but make sure to include an explanation for the answers. Actions Cash Flow Position Time, underlying price, shares t=0, S = 100 t=1, t=2, Balance Problem 3. (10 points) A broker writes a long call ladder spread with expiry date T = 2 months and payoff function ST 120 Payoff VI 0 ST 80 20 140 - ST The risk-free interest rate is r = 0.02 and the initial price of the underlying So = 90. (a) Compute the fair price of the spread using a 2-level tree model with St = 1, u = 1.2 and d = 0.85. For simplicity, the prices of the underlying are given below. S2 = 129.6 Si 108 So = 90 S2 = 96 Si = 76.5 S2 = 65.025 (b) Consider the price path up-up and describe the cash flow of the corresponding delta-hedging procedure for the broker selling this option. You may fill the chart below, but make sure to include an explanation for the answers. Actions Cash Flow Position Time, underlying price, shares t=0, S = 100 t=1, t=2, Balance

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