Question 1 [20 marks]

Current stock price S is $22. Time to maturity T is six months. Continuously compounded, risk-free interest rate r is 5 percent per annum. European options prices are given in the following table:

Strike Price Call Price Put Price

K1=$17.50 $5.00 $0.05

K2=$20.00 $3.00 $0.75

K3=$22.50 $1.75 $1.75

K4=$25.00 $0.75 $3.50

(a) What is the aim of a long (or bottom) straddle strategy? Create a long straddle by buying a call and put with strike price K3=$22.50 [10 marks]

(b) What is the aim of a short (or top) strangle strategy? Create a short strangle by writing a call with strike price K3=$22.50 and a put with strike price K2=$20. [10 marks]

Question 2 [10 marks]

(a) Why is the binomial model a useful technique for approximating options prices from the Black-Scholes model? [5 marks]

(b) Describe some applications and uses of this model. [5 marks]