Question 4. (This question has three parts: I, II and III)

A stock price is currently $60. Over each of the next two six-month periods, it is expected to go up by 6% or down by 6%. The risk-free interest rate is 5% per year with semi-annual compounding.

Part I.

Use the two-step binomial tree model to calculate the value of a one-year European put option with an exercise price of $61.

Part II.

Discuss how you can hedge risk when you initially write the put option?

Part III.

Assume six months have passed, discuss how you can hedge risk when you realize that the stock price is $63.6?