The CEO of BE has just received a grant of 500,000 call options (at-the-money warrants on the firm's stock). Assume that the options have 10 years to expiration, and the variance of return on the firm's stock is 0.04 (annualized).

(a) Find the value of this grant using a two-period binomial tree. Use $41 as today's price of BE stock

(b) CEOs normally hold undiversified portfolios, which should make them more risk-averse. We can capture that by using probabilities that are more "pessimistic" than risk-neutral probabilities. With that in mind, redo the valuation in part (a) using probabilities of 0.3 for the up state and 0.7(=1-0.3) for down state instead of the risk-neutral probabilities you calculated earlier.

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Valuation of CEO Stock Options with Binomial Tree a Using RiskNeutral Probabilities Step 1 Define Pa... View the full answer