Question: Question 4 Consider a stock currently worth $80 (S = 80) that can go up or down by 25 percent per period. The exercise price
Question 4
Consider a stock currently worth $80 (S = 80) that can go up or down by 25 percent per period. The exercise price is $80 (X = $80) and the risk-free rate is 5 percent (r = .05). The option will expire at the end of the second period (t = 2). You try to find a theoretically fair value of the call using a two-period binomial option pricing model. (Hint: See Ch 16 Teaching Notes and Excel Spreadsheet)
| t = 0 |
| t = 1 |
| t = 2 |
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| Suu = (c) |
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| Su = (a) |
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| S = $80 |
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| Sud = (d) |
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| Sd = (b) |
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| Sdd = (e) |
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| Cuu = (f) |
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| Cu = (i) |
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| C = (k) |
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| Cud = (g) |
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| Cd = (j) |
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| Cdd = (h) |
What are three possible stock prices ((c), (d), (e)) at time t = 2?
Compute three values at expiration (t = 2) of a European call option ((f), (g), (h)).
Compute two values at time t = 1 of European call options ((i), (j)).
Find the theoretical fair value of the call option today.
Compare the call price computed in #1 part (6). Which price is higher? Why is that price higher?
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