Question

A stock price is currently $36. During each three-month period for the next six months it is expected to increase by 9% or decrease by 8%. The risk-free interest rate is 5%. Use a two-step tree to calculate the value of a derivative that pays off (max[(40-S_T),0])² where ST is the stock price in six months.

1. What are the payoffs at the final nodes of the tree? [1 mark]
2. Use no-arbitrage arguments (you need to show how to set up the riskless portfolios at the different nodes of the binomial tree). [2 mark]
3. Use risk-neutral valuation. [1 mark]
4. Verify whether both approaches lead to the same result. [1 mark]
5. If the derivative is of American style (S_T in the payoff function refers to the stock price when the option is exercised), should it be exercised early? [1 mark]

Answer 1

1.