We looked at the following example of a stock with a spot price of $100 and no dividends or carrying costs. We characterized the volatility of the stock using the parameters u=1.5 and d=2/3. Note that these are inverses. We assumed the risk-free rate was 3%, satisfying the relationship. u>(1+r)>dor1.5>1.03>2/3 The result is a risk neutral probability of q=(1+rd)/(ud)=0.436. Finally, we considered the risk neutral distribution for a three-period model (T=3) and used it to value a call with a strike of $125. I refer to this as the baseline model. The model resulted in a premium of $23.48 (rounded). Slides 3440 show more detail about the technique. PowerPoint Slides Used in Class (link) 4. There are other option structures. For example, consider a binary option that pays off only if the stock price ends up higher than today. The initial spot share price is S0=$100. If the price at time T=3 is higher than $100, you receive $50; if not, you receive 0 . Use the baseline model to determine the premium on the binary options. 5. Extend the baseline model to four periods. There will now be five possible prices and a probability of each. Use the revised model to value a call with a strike of $125