QUESTION

The market price of a security can be modelled by assuming that it will either increase by 12% or decrease by 15% each month, independently of the price movement in other months. No dividends are payable during the next two months. The continuously-compounded monthly risk-free rate of interest is 1%. The current market price of the security is 127 .

i.Use the binomial model to calculate the value of a two-month European put option on the security with a strike price of 125. [4 marks]

ii.Calculate the value of a two-month American put option on the same security with the same strike price. [3 marks]

Calculate the value of a two-month American call option on the same security with the same strike price.