The USDISK exchange rate is currently ISK 140 per USD 

1. The continuously compounded risk-free rates in ISK and USD are 5% and 3%, respectively. The volatility is 15% per annum.

 (a-b) Use a five-step binomial tree to value an 10-month European put option on USDISK, with a strike equal to the 10-month forward USDISK exchange rate.

 (c-d) What is the price if the put is American? In which nodes are gains made by being able to exercise early? Which nodes form the optimal exercise boundary for the holder of the put option (i.e. when does the holder actually exercise the option)? 

(e) What is the initial delta for the European put? What does it imply for a trader that has sold the European put on USD10,000andwants to hedge that position? How does the delta change and his hedge if the exchange rate moves up in the first step? How does the delta change and his hedge if the exchange rate moves down in the first step?

Answer rating: 100% (QA)

Here are the answers to the questions a To value the European put option on USDISK using a 5step binomial tree we first need to calculate the riskneut... View the full answer