Suppose the stock price of Tesco (TSCO.L) changes only once a month: either it goes up by 22% or it falls by 20%. Its price now is 40. The interest rate is 12.7% per year, or about 1% per month.

Required:

a) Suppose a one-month call option on this stock has an exercise price of 40, what is the option delta?

(6 marks)

b) Show how the payoffs of this call option can be replicated by buying Tescos stock and borrowing.

(6 marks)

c) Use the risk-neutral method to calculate the value of a one-month call option with an exercise price of 40.

(6 marks)

d) Construct a two-month binomial tree. What is the value of a two-month call option with an exercise price of 40?

(6 marks)

e) Discuss why a one-month put with the same exercise price can be calculated by using put-call parity.

(6 marks)