Question 2.

Assume the following information:

Exercise price (X) = $21

Risk-free rate (r) = 10%

S₀ = $20

U = 1.2

P = .81

It might be helpful to use the BINOMDIST command in Excel.

(a) Calculate the price of a call option using the binomial tree method using 2,4 and 6 time periods. What happens as the number of time periods increases? Why?

(b) Recalculate the call prices assuming p= .5

(c) What are the differences in you results? Interpret them.

(d) What happens as you increase the strike price to $30? Does this fit with option theory?

(e) Assume the original set of information but increase the volatility, i.e. let U=1.5 and D=.67. What happens to the price of the call option? Does this conform with option theory?

(f) Calculate the value of a put option using risk-neutral probability.

(g) Verify parts (f) and (g) using put-pall parity.

Needs to be in Excel With Formulas