Question 3(10 marks)

Suppose that the risk-free rate is 12% p.a. compounded continuously. The current price (S₀) of a stock is $15. We model the evolution of the stock prices using a 3-step Binomial tree approach. In reality, over any four-month period, there is a 60% chance that the stock price will rise by 29.67% and a 40% chance that the stock price will fall by 22.88%. This is illustrated in the figure attached:

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