a) Consider a three-period binomial model (t = f0; 1; 2; 3g), with a risky non-dividend paying

stock, Prudential, which is currently trading for 1,350. In each period the stock can go up

by 30% or down by 20%. The risk-free rate is 2% in the first period, 3% in the second period,

and 1% in the third period.

Using the risk-neutral pricing method, what is the no-arbitrage value today of an at-themoney

European put option on Prudential stock with maturity date t = 3? Would the value

of the option change if it was American? Explain.

b) Explain intuitively how volatility in the underlying stock price affects the prices of both call

and put options written on the underlying stock.

10 marks

a) Consider a three-period binomial model (t = {0, 1, 2, 3}), with a risky non-dividend paying stock, Prudential, which is currently trading for 1,350. In each period the stock can go up by 30% or down by 20%. The risk-free rate is 2% in the first period, 3% in the second period, and 1% in the third period. Using the risk-neutral pricing method, what is the no-arbitrage value today of an at-the-money European put option on Prudential stock with maturity date t = 3? Would the value of the option change if it was American? Explain. b) Explain intuitively how volatility in the underlying stock price affects the prices of both call and put options written on the underlying stock