In this project, you will suppose it is on 1 January 2018, and you will form trading strategies based on information available up to 1 January 2018. Afterwards, you will jump forward to 1 January 2019, and assess the profit from your options strategies, based on the stock price at this later date. In your answer, use European options on non-dividend-paying stock. Assume that the estimated volatility of IBM per annum is calculated as 30.5% (or 0.305). The IBM stock price on 1 January 2018 is 2370 pence. The 12-month sterling rate for LIBOR on 1 January 2018 is 1.5% (or 0.015)”

“Consider the binomial option pricing model when IBM stock price is permitted to progress two periods into the future. The current (period 0) stock price is 2370 pence on 1 January 2018. The stock price evolves by either rising 50% or dropping by 25% each period. Based on the conditions provided in this project, assume that European call and put are written on IBM stock with exercise price 2370 pence and expiration date at the end of period 2.”

Question 1

“Calculate the period 0 call and put option prices.”

“Comment and suggest how to improve the accuracy of the binomial option pricing model”

Question 2

“Suppose you have a long position in the stock on 1 December 2017. How would you hedge against price declines for a one-year period, using puts, calls and spread options?”

Answer rating: 100% (QA)

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