Question 3

A corporate treasurer is contemplating buyinga five-month down-and-out put optionon the Australian dollar with an exercise price equal to the current spot rate of the Australian dollar ofUSD0.7200and a barrier atUSD0.6000. Her treasury analyst estimates that the Australian dollar will either rise or fall by5%during eachone- month period. The term structure is flat in both Australia and the US, with risk free rates of1.5%and0.5%p.a. respectively, continuously compounded.

Required

1. (a)Build a five-period binomial model in EXCEL to price the down-and-out put option. Make sure you include a binomial tree diagram for the exchange rate.

1. (b)Compare the price of the down-and-out put option with that of a standard European put option priced using a five-period binomial model. Account for the difference in price.