Problem 1

Consider the following binomial option pricing problem involving a European call. This call has two periods to go before expiring i.e., n =2 periods. Its stock price is 30, and its exercise price is 25. The risk-free rate is 0.05, the value of u is 1.15, and the value of d is 0.90. The stock pays no dividend. (You can borrow any additional funds required at the risk-free rate, and any excess funds should be invested at the risk-free rate.)

A. Find the value of stock at time-period 1, and time-period 2

B. Find the value of the call at time-period 0, time-period 1 and time-period 2

C. Find the hedge ratio at time-period 0 and time-period 1

D. Find the value of hedge portfolio at time 0, time-period 1 and time-period 2. Show that no

arbitrage exists. Also make any necessary changes to the hedge portfolio based on the

adjustment to the hedge ratio.

E. What will be your strategy if the call is overpriced and underpriced?