QUESTION 2: (15 Marks)

1. (4 marks) Calculate the two period binomial call value (X = 45) for S₀ = 50, u = 1.2, d = .8, r = 5% per period. Calculate the one period call value and explain why the two period is worth more.
2. (2 marks) Calculate the corresponding put price in (a). Show that your call and put prices satisfy put-call parity.
3. (9 marks) Show how to make risk free profits in (a) if the current market price of the call is $12 at t₀, and then at t₁ the calls market price is $18 if the stock goes up but $3 if the stock goes down. Use 1000 calls in your hedge (and adjust it through stock) Explain your results.