FINANCIAL MODELING

BINOMIAL MODEL

2. Assume a one-period binomial model framework. The government has approached BP PLC to buy 5 million gallons of gasoline in 3 months at a price of $1.85 per gallon. The two parties have agreed that the government will buy gasoline from BP PLC provided that the market price of gasoline is bigger than $1.85 per gallon. Gasoline is currently selling on the wholesale market at $1.65 per gallon and has a standard deviation of 46% per annum. The continuously compounded risk-free rate is 6% per year. a) What is the total cost of this contract for the government? b) Consider for the moment the possibilities of an arbitrage. i. If the total cost of gasoline from another gasoline supplier in the market is over $550,000, create an arbitrage trading strategy. ii. If the total cost of gasoline from another gasoline supplier in the market is below $500,000, create an arbitrage trading strategy. c) Suppose that Treasury note sells for $1.00. Which other trading strategy can the government pursue to replicate the agreement in (a)? [3] 2. Assume a one-period binomial model framework. The government has approached BP PLC to buy 5 million gallons of gasoline in 3 months at a price of $1.85 per gallon. The two parties have agreed that the government will buy gasoline from BP PLC provided that the market price of gasoline is bigger than $1.85 per gallon. Gasoline is currently selling on the wholesale market at $1.65 per gallon and has a standard deviation of 46% per annum. The continuously compounded risk-free rate is 6% per year. a) What is the total cost of this contract for the government? b) Consider for the moment the possibilities of an arbitrage. i. If the total cost of gasoline from another gasoline supplier in the market is over $550,000, create an arbitrage trading strategy. ii. If the total cost of gasoline from another gasoline supplier in the market is below $500,000, create an arbitrage trading strategy. c) Suppose that Treasury note sells for $1.00. Which other trading strategy can the government pursue to replicate the agreement in (a)? [3]