Assume you are working for an investment bank. You have a client wanting to purchase a European call option on a dividend paying stock. The stock is currently priced at $100 and a dividend is expected in 6 months’ time. The dividend is expected to be 10% of the stock price when the dividend is paid (i.e 10% of the stock price in 6 months’ time). The strike price is $85 and the time to maturity of the option is 1 year. Assume a continuously compounded risk free rate of 10% p.a and that stock prices will move by +/-10% each 6 months.

a)  Use a two period binomial model to price the option. Show all workings.

b)  Now assume that you wish to delta hedge your exposure to the call option. Assuming that the

stock price increases in 6 months and in 1 years’ time, outline the hedging strategy. Show all cashflows from the commencement to the completion of the hedge.

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The two period binomial model can be used to price the option The parameters for the model are as fo... View the full answer