Question
Using binomial trees, calculate the value of an European call option (in the beginning of the first year) with the following characteristics: Underlying asset current
Using binomial trees, calculate the value of an European call option (in the beginning of the first year) with the following characteristics:
Underlying asset current value S0 = 150.
Option exercise price X = 150.
Up movement in period 1 u1 = 1.1.
Down movement in period 1 d1 = 1/u1.
Up movement in period 2 u2 = 1.3.
Down movement in period 2 d2 = 1/u2.
The risk-free asset exists. Risk-free rate in period 1 rf1 = 5%
Risk-free rate in period 2 rf2 = 3%.
Time to expiration T = 2 years.
Number of time periods per year: 1.
The steps you will need to follow include
Create the event tree for the underlying risky asset.
Calculate whether to exercise the options and payoffs.
Use either replicating portfolio technique or risk-neutral probability technique to value the option. Hint: S u 1 = S0 u1
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