Question 2

A currency currently trades at a price of $0.7650. In a two-period binomial model, its price can go up 15% or down 10% per period. Assume that the risk-free rate is 5% and that one period represents half a year.

(a) Apply the binomial model and find the price of a European put option that matures in two periods and has a strike price of $0.7600.

(b) Using your answer from above, find the number of units of the currency that is required to construct a risk-free hedge at each point on the binomial tree against 100 put options.

(c) Analyse the need for hedging currency risk.

Use continuous compounding to answer the question.