Tom Curtis has prepared a hypothetical problem for you and your group to solve. He wants you to utilize the two-period binomial option pricing model to solve certain problems. If your team passes this test, you might soon be developing derivative strategies for Ricardo International to use.
Individually conduct research on two different models used to price call options. Detail each model in a Word document and focus on comparing and contrasting the models. Post your document to the Small Group Discussion Board.
As a group, combine your efforts to solve the following:
Consider a two-period, two-state world. Let the current stock price be $35 and the risk-free rate be 5%. In each period, the stock price can either go up by 10% or down by 10%. A call option expiring at the end of the second period has an exercise price of $30.
- Find the stock price sequence.
- Determine the possible prices of the call at expiration.
- Find the possible prices of the call at the end of the first period.
- What is the current price of the call?
- What is the initial hedge ratio?