Given Data S0 = 200 r = 5% (continuously compounded annual rate) u =
Question:
Given Data
S0 = 200
r = 5% (continuously compounded annual rate)
u = 1.2 and d = 0.8
u and d are multiplicative factors per 1-step period in a binomial tree
Each step represents 1 year
You may take it as given that the risk neutral probability of an up move is 0.6282.
If you go long Contract X then at t = 2
- If the stock price is greater than $250: you have to pay $44 to the counterparty
- If the stock price is less than $150: you will receive $100 from the counterparty
- If the stock price is between $150 and $245: you will receive $68 from the
counterparty
a) Using risk-neutral pricing, find the price of going long the contract at t = 0 assuming there is no
arbitrage.
b) Suppose Contract X were trading at a price that was $1 lower than your answer to part a.
Construct an arbitrage such that your profit is realized at t = 0 and the net cash flows are equal
to zero at all other times, regardless of what happens. Make sure to specify all the trades at t = 0
as well as all the actions you would take at t = 1, for both the up and down states (you do not
need to show what happens at t = 2).
Income Tax Fundamentals 2013
ISBN: 9781285586618
31st Edition
Authors: Gerald E. Whittenburg, Martha Altus Buller, Steven L Gill