Basic Data Extraction and Organizing

The four scenarios require calculations of option pricing with both call and put
options. Two of them are based on European Model while the other 2 are
American model based.

The primary difference between the two is that the European option can be
exercised only at the exercise date, whereas an American option can be
exercised at any time on or before the exercise date.

Below are the extracts of the data processed and calculated on Excel from the
given information.

All the answers for the questions can be extracted from the explanation
presented below:

Multi-
BINOMIAL OPTION PRICING Period
Inputs
Option Type: 1=Call, 0=Put 0
Stock Price Now $4.00
Up Movement / Period 25.00%
-
Down Movement / Period 25.00%
Riskfree Rate / Period 10.00%
Exercise Price $4.00
Time To Maturity (Years) 2.00
Number of Periods 2

Now
Period 0 1 2
Time 0.000 1.000 2.000

Stock $4.00 $5.00 $6.25

$3.00 $3.75
$2.25
 Put $0.12 $0.08 $0.04
$0.26 $0.19
$0.51

Replicating Portfolio

Stock Shares Bought (Sold)

(0.089) (0.056) (0.031)
(0.216) (0.155)
(0.453)

Money Lent (Borrowed)

$0.48 $0.36 $0.24
$0.90 $0.76
$1.53

Binomial tree model for pricing American calls, puts

Input data
Type of option (1 for call, 2 for put) 2
Stock price $4.00
Exercise price $4.00
Today's date 04-Sep-17
Exercise date 04-Sep-19
Riskfree interest rate 10%
StDev of annual return

Duration (trading days) 730

Parameters for binomial tree

Up factor 1.250
Down factor 0.750
Probability of up 0.501
Probability of down 0.499

Future prices 0 1 2 3 4 5
9.76562 12.2070
0 4 5 6.25 7.8125 5 3
5.85937 7.32421
1 3 3.75 4.6875 5 9
3.51562 4.39453
2 2.25 2.8125 5 1
2.10937 2.63671
3 1.6875 5 9
1.26562 1.58203
4 5 1
0.94921
5 9
Goal Seek set cell: -0.4990387
$1.0
Option values 0 0 2 3 4 5
0.4990386
0 8 0 0
1 1
2 1.75
3
4
5

A) Since options tend to be more sensitive to price changes (on a percentage basis) than are
the underlying assets, a small investment can yield a much greater percentage return. It is not
the same as leverage since there is no borrowing involved, but the effect is similar: small
changes in asset price yield large changes in portfolio value.

B) Long puts or short calls have a similar payoff to shorting the stock, at least over a certain
range of stock prices. By adjusting the number of options held over time it is possible to
replicate a put fairly closely.

C) A put on a stock you own serves as insurance against downward moves. It gives you the
right to sell the asset at a fixed price should the market turn sour.
D) Again, options allow you to hedge asset positions, though there are a few catches; most
importantly the market must be liquid and continuously tradable since a successful option based
hedge will probably need to be adjusted as prices move.

E) A straddle or strangle position allows you to bet on the volatility of an asset without having to
worry about the direction the price will move.