Question

Suppose that, in each period of a two-period stock price model, the cost of a security either goes up by a factor of u = 2 or down by a factor d = 1/2. Assume the initial price of the security is $80 and that the interest rate r is 0.

a). Compute the risk neutral probabilities p (price moves up) and q = 1−p (price moves down) for this model.
b). Sketch a diagram of this two period stock price model.
c). Assuming the strike price of a European call option on this security is $70, compute the possible payoffs of the call option given that the option expires in two periods.
d). What is the expected value of the payoff of the call option?

Answer 1