Consider a CRR model with T=2,S 0  =$100,S 1  =$200 or S 1  =$50, and an associated European contingent claim whose value at its exercise time T=2 is given by X=max{S 0  ,S 1  ,S 2  } Assume that the risk free interest rate is r=0.1

(a) Draw the binary tree and compute the arbitrage free initial price of the European contingent claim at time zero.

(b) Determine an explicit replicating strategy for this contingent claim.

(c) Suppose that the option in (a) is initially priced $2 below the arbitrage free price.



Describe a strategy (for trading in stock, bond and the ECC) that is an arbitrage.

Answer rating: 100% (QA)

a To draw the binary tree we start at time zero and consider the two possible values for the stock price at time T 1 which are S 200 and S 50 At time ... View the full answer