Question

Throughout this problem assume that all cash flows are realized at the end of any given period. All periods are one year long. The risk free interest rate is 6% per year, while the cost of equity is 7% per year for all companies under consideration.

The stock price for company C is described by the binomial model. Company C’s current stock price is $300, and company C does not make any dividend payments. Next year, the stock price of company C can either increase by 20% or decrease by 10%. A put option with an exercise price of $310 is traded on the stock of company C.

i) What are the possible stock prices of company C next year?

ii) What are the possible payoffs for the put option next year?

Answer 1

Solution:

i) Possible stock prices of Company C next year can be:

$300 + $300*20% = $360

$300 - $300*10% = $270

ii) Put option is downside betting.

Payoff= Maximum(Exercise price - Stock price,0)

  Possible payoffs for the put option next year:

Exercise price:$310 (given)

If the stock price raises to $360, then the put option will lapse. In this case put is out of money as stock price is greater than exercise price.

If the stock price falls to $270 then the put option will be exercised and payoff will be $40 i.e. $(310-270). In this case put is in the money as stock price is lower than exercise price.