Binomial Trees (5 marks) A stock price is currently $76. During each two-month period for the next four months it is expected to increase by 10% or decrease by 10%. The risk-free interest rate is 6%. Use a two-step tree to calculate the value of a derivative that pays off (max[(ST-75),0]) 2 where T S is the stock price in four months.

a. Use no-arbitrage arguments (you need to show how to set up the riskless portfolios at the different nodes of the binomial tree).

b. Use risk-neutral valuation.

c. Verify whether both approaches lead to the same result.

d. If the derivative is of American style, should it be exercised early?