Question 2 Part a 1. A stock price is currently $35. It is known that at the end of three months it will be either $31 or $39. The risk-free interest rate is 3% per annum with continuous compounding. Using the binominal tree valuation method, estimate the value of a three-month European call option with the strike price of $30. [10 marks] ii. The stock price is $35. The strike price for a European call and put option on the stock is $30. Both options expire in 9 months. The risk free interest is 7% per annum and the volatility is 20% per annum. Using the Black-Scholes-Merton model, calculate the prices of European call and put options on a non-dividend-paying stock [10 marks] Part b i. Considering the lower bounds of option prices, create a scenario in which a call or a put option (choose one of them) is underpriced and explain how an arbitrageur can take advantage of of this opportunity. [10 marks] ii. Explain the differences between using options or futures in terms of hedging purposes. (5 marks] [Total 35 marks)