Question

Answer
3

Expected Return on risk free Bond = 1 = 0.0612 = 1.015.

In familiar notation of Cox-Ross-Rubenstein framework,
U (Up Price) = 1.06, D (Down Price)= .95
Risk Neutral favorable Probability, =

1.015.95
1.06.95

= 0.591

Possible Values of the Binomial Stock

S2,1=47.7*1.06
= 50.562
S1,1=45*1.06
=47.7
S2,2=47.7*.95=
42.75*1.06 =
45.315
S0=
45

S1,2=45*.95
= 42.75

S2,3=42.75*0.95
= 40.6125

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a. Calculating Price of a Call Option

2.656

50.562
f(S2,1), or F(U)= 4.562

47.7
K= 46
45.315
f(S2,2)=0
45
42.75

40.6125
Payoff = 0

Backward Induction

We use Backward Induction.

Step 1: Compute Value of option at S(1,1) ie, where Stock Prices are
47.7., using the Single Period Option Valuation formula
exp(rT )[f (SU ) + (1 )f (SD)]. =

1
1.015

(0.591 4.562 + 0) =

2.656
It is elementary to notice why we have striked off Stock prices at Period 1 and
would use this Value at Payoffs at period 1 Since 2.656> 1.7=47.7-45.315,
concurrent with Practice.
Step 2:

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Reiterating the process towards t=0, we get Value (Price) of Option

(Distinguish between Option ie call and stock is also necessary in this
exercise).
=

1
1.015

(0.591 2.656 +

0) he last 0 arises from the fact that any linear transformation of 0, used to compute Val
is zero. = 1.547
Again, Notice that the high Strike Price of the Call option let us reduce steps
considering possible non-zero payoffs.

b. Pricing the Put Option

-0.276

50.562
f(S2,1), or F(U)= 0

47.7
K= 46
45.315
f(S2,2)= -0.685

??
42.75

40.6125
Payoff = -5.3875

Backward Induction

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We use Backward Induction.

Step 1: Compute Value of option at S(1,1) ie, where Stock Prices are 47.7.,
using the Single Period Option Valuation formula exp(rT )[f (SU ) + (1
1
)f (SD)]. =
(0.591 0 + 0.409 0.685) = 0.276
1.015

Step 2: Compute Value of option at S(1,2) ie, where Stock Prices are 42.75.,
using the Single Period Option Valuation formula exp(rT )[f (SU ) + (1
1
)f (SD)]. =
(0.591 0.685 + 0.409 5.3875) = 2.57
1.015

Step 3: Compute Value of Option at t=0

=

1
1.015

(0.591 0.276 + 0.409 2.57) = 1.196

Note Put Options have negative Prices, Buyer or the party who gets right to
Put the option pays for signing the contract. Again, since Payoffs are truncated
at 0, price is technically non-positive.
Price of Put =|-1.976| =1.976
c)
Put-Call Parity
c + PV(Stike Price) = p + s
Where:
c = the current price or market value of the call
p = the current price or market value of the put
s = the current market value of the Stock, PV is present value, with suitable
discounting.
+ ( ) = 1.547 +

46
6
0.0612

= 46.19

+ = 45 + 1.19 = 46.19
We have just verified that the Put-Call Parity (No-Put-call Arbitrage) is
preserved by this 2 Period Binomial Option Pricing method.
Thank You.
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