Gloria Delgado owns 500 shares of Rio Tinto stock, listed on Nasdaq. Today is November 12 th
Question:
Gloria Delgado owns 500 shares of Rio Tinto stock, listed on Nasdaq. Today is November 12th, 2020, and the stock, currently trading at $63, is already down since the time Gloria purchased it. Fearing further declines, she decides to hedge with Rio Tinto put options with a strike of $60 and expiring in April 2021 (a 5-month maturity). As a financial intermediary, you are willing to write the options to Gloria and need to price them.
To this end, you look up the implied volatility from some traded options on Rio Tinto and see that it is at 35% per annum. You also check Rio Tinto stock and see that the company will pay a dividend of $3 in 2.5 months from today and a dividend of $5 in 6.5 months from today. The Reserve Bank of Australia (RBA) has recently cut the risk-free rate of interest to 0.10% p.a. (continuously compounded)
In all the answers, please show the details of your work
- Use a three-step binomial tree to calculate the option price.
Round u and d to 7 decimal digits.
For all other calculations, round to 4 decimal digits at each step.
- What do you need to do in order to delta hedge the option? Be specific about the necessary hedging strategy. Round to 2 decimal digits.
- An analyst working for the intermediary questions your choice of the pricing model and claims that you should have used the BSM model. How would you defend the choice of using the Binomial model?
South western Federal Taxation 2017 Corporations, Partnerships, Estates and Trusts
ISBN: 9781305874336
40th edition
Authors: William H. Hoffman, William A. Raabe, David M. Maloney, James C. Young