Question: 2. Consider a two-period binomial model in a discrete market with one risky asset and one riskless asset. The interest rate r=1/3 is fixed and

2. Consider a two-period binomial model in a discrete market with

2. Consider a two-period binomial model in a discrete market with one risky asset and one riskless asset. The interest rate r=1/3 is fixed and the share prices at times 0,1,2 are defined by So = 8, S = SY S2 = SY, where Y.Y. Y are iid random variables with PlY = 3) + P(Y = 1/2) = 1. (a) [12 marks] Write down the two-step binomial tree and find the arbitrage-free time 0 price of the option claim C = (3-S2) (b) [11 marks Identify the initial hedging portfolio in (a) above. (C) (2 marks) Now, discuss what happens in the case P(Y = 4/3)=P(Y=1/2) = 1/2. 2. Consider a two-period binomial model in a discrete market with one risky asset and one riskless asset. The interest rate r=1/3 is fixed and the share prices at times 0,1,2 are defined by So = 8, S = SY S2 = SY, where Y.Y. Y are iid random variables with PlY = 3) + P(Y = 1/2) = 1. (a) [12 marks] Write down the two-step binomial tree and find the arbitrage-free time 0 price of the option claim C = (3-S2) (b) [11 marks Identify the initial hedging portfolio in (a) above. (C) (2 marks) Now, discuss what happens in the case P(Y = 4/3)=P(Y=1/2) = 1/2

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