Using the calibrated binomial tree from Question 10 (S0 = .07, Sd = 8.148%

and Su = 9.9952%), answer the following:

a. Show in a binomial tree the following values at each node:

i. The values of an option-free, one-period, 10.5% coupon bond (F = 100).

ii. The values of an option-free, two-period, 10.5% coupon bond (F = 100).

iii. The values of an embedded call option on a two-period, 10.5% callable bond with the call price equal to CP = 101 and callable in period 1.

iv. The values of a two-period, 10.5% coupon bond callable at CP = 101 in period 1.

b. Construct a portfolio with the one-period and two-period 10.5% option-free bonds that replicates the period 1 up and down values of the embedded call option on the two-period, 10.5% callable bond (hint: try n1 = −.70463 and n2 = .701457). What is the current value of the replicating portfolio? Does the current value of your replicating portfolio match the current value of the callable bond’s embedded call option? Comment on the arbitrage-free features of the calibration model. For more insight into this question, see Appendix F.