Consider a compound put option on a put option (put on a put) which gives the...

 

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Consider a compound put option on a put option (put on a put) which gives the right to sell at time T₁> 0 a put option for a price K₁. The underlying put option is written on a stock with strike price K2 and maturity T2 > T₁. The simplest model for pricing a compound put option is a two-step binomial tree model with time steps T₁ and T₂. Use a two-step binomial tree model to compute today's (t = 0) arbitrage-free price of a put on a put with T₁ 1 and T₂ = 2 (measured in years). The current stock price is So = $50 and over each of the next two one-year periods it is expected to go up by 20% or down by 20%. The strike price of the put option on the stock (with maturity T₂ 2) is K₂ = $52, and the strike price of the compound put option on the put option (with maturity T₁ = 1) is K₁ = $5. Assume that the risk-free interest rate is 5% per annum. = Consider a compound put option on a put option (put on a put) which gives the right to sell at time T₁> 0 a put option for a price K₁. The underlying put option is written on a stock with strike price K2 and maturity T2 > T₁. The simplest model for pricing a compound put option is a two-step binomial tree model with time steps T₁ and T₂. Use a two-step binomial tree model to compute today's (t = 0) arbitrage-free price of a put on a put with T₁ 1 and T₂ = 2 (measured in years). The current stock price is So = $50 and over each of the next two one-year periods it is expected to go up by 20% or down by 20%. The strike price of the put option on the stock (with maturity T₂ 2) is K₂ = $52, and the strike price of the compound put option on the put option (with maturity T₁ = 1) is K₁ = $5. Assume that the risk-free interest rate is 5% per annum. =

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Binomial Tree Model for Compound Put on a Put 1 Setting Up the Tree The tree will have three nodes a... View the full answer