This question concerns the two-step binomial tree method of pricing

Options.

You have the following information on a European Put Option:

Expiry: 2 Years

Type: European

Stock Price: 120.0

Strike Price: 130.0

Risk Free Rate: 2%

It is estimated that volatility will be 25% per annum over the next two

years. Assume a two step tree (with each step representing one year,

t=1.0) :

a) Using the following formulas:

calculate u, d and p.

b) Briefly, explain what u, d and p are.

c) Using the u, d and p; calculated in a) draw a two-step tree and

calculate the stock price at each node.

d) Show the values of the Put Option at each of the three, two-year

nodes.

e) Using p, and discounting using exp(-rt) work back through the tree

to calculate the Option value.

f) Give one advantage and one disadvantage of the binomial tree model

compared with the Black Scholes model for valuing Options.