Question: Suppose that S = $100, = 30%, r = 6%, t = 1, and = 0. XYZ writes a European put option on

Suppose that S = $100, σ = 30%, r = 6%, t = 1, and δ = 0. XYZ writes a European put option on one share with strike price K = $90.

a. Construct a two-period binomial tree for the stock and price the put. Compute the replicating portfolio at each node.

b. If the firm were synthetically creating the put (i.e., trading to obtain the same cash flows as if it issued the put), what transactions would it undertake?

c. Consider the bank that buys the put. What transactions does it undertake to hedge the transaction?

d. Why might a firm prefer to issue the put warrant instead of borrowing and repurchasing shares?

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