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You are given following information regarding 3-step binomial tree: 1. Each step is 3-month 2. The current stock price S(0) = 60 3. Time to
You are given following information regarding 3-step binomial tree:
1. Each step is 3-month
2. The current stock price S(0) = 60
3. Time to expiry is 9 months
4. The strike price K = 65
5. The continuously compounded risk free rate is 6%
6. the stock pays no dividend
7. volatility = 17%
8. Use log-normal expressions (Jarrow-Hud form) to calculate how much stock price goes up or down in each time step
9. The option is a put option with following specific characteristics: Put option can be exercised only at the end of 6 month or at expiry.
(a) Calculate u
(b) Calculate d
(c) Calculate risk neutral probability
(d) Calculate put option value at time zero
(e) Calculate replicating portfolio at time zero
(f) Under general binomial pricing model, we require u > e(r)h > d where r is continuously compounded risk free rate, is continuously compounded dividend rate, h is size of time step. Prove that if this condition is violated then arbitrage opportunity exist.
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