Documente Academic
Documente Profesional
Documente Cultură
This is a preliminary draft of a chapter of Principles of Finance with Excel. 2001 2005 Simon Benninga
(benninga@wharton.upenn.edu ).
page 1
Overview
In Chapter 25 we discussed the Black-Scholes formula, the most common method for
pricing options. In this chapter we discuss the other major technique for determining option
prices, the binomial option pricing model. This model gives some insights into how to price an
option, and its also used widely (though not as widely as the Black-Scholes equation).
The basis of the binomial model is a very simple description of stock price uncertainty.
Heres an example: Suppose the current stock price of MicroDigits (MD) is $100. What can
you say about the MD stock price one year from now? The binomial model assumes that the
price of the stock in one year will either go up by a certain percentage or down by a certain
percentage. Heres an example:
A
1
2 Up
3 Down
4
5 MD stock
6
7
8
9
10
11
12
13
14
15
16
30%
-10%
<-- =100*(1+B2)
90
<-- =A7*(1+B3)
100
Date 0
today
Date 1
one year
from now
Date 0
today
<-- =C6/A7-1
-0.1
<-- =C8/A7-1
Date 1
one year
from now
page 2
In the example above the MD stock price will either go up by 30% or down by 10% one
year from today. This means that the return on the stock will be either 30% or -10% (cells C13
and C15).
It is difficult to believe that such a simple description of stock price uncertainty could be
useful. However, if we extend the model to more periods, it turns out that the binomial model
can describe a wide range of stock price behaviors. In the example below we assume that the
price of MD stock goes up in each of the next two years by 30% or goes down by 10%. This
means that there are three possible outcomes for the stock price at Date 2: It can be either $169,
$117, or $81.
A
1
2 Up
3 Down
4
5
6
7
8
9
10
30%
-10%
169
<-- =C6*(1+B2)
117
<-- =C6*(1+B3)
81
Date 2
two years
from now
<-- =C8*(1+B3)
130
100
90
Date 0
today
Date 1
one year
from now
If we extend the model to more periods, well get a wide range of possible prices and
returns. In the spreadsheet below we look at stock prices after 10 periods:
page 3
1
2 Up
3 Down
4
5 Date
0
6
7
8
9
10
11
12
13
14
15
16
17
100.00
18
19
20
21
22
23
24
25
26
27
30%
-10%
10
1378.58
1060.45
815.73
627.49
482.68
371.29
285.61
219.70
169.00
130.00
117.00
117.00
334.16
197.73
152.10
81.00
270.67
160.16
94.77
187.39
110.88
65.61
219.24
168.65
129.73
99.79
76.76
59.05
316.69
243.61
144.15
85.29
457.44
351.87
208.21
123.20
72.90
390.97
231.34
136.89
660.74
508.26
300.75
177.96
105.30
564.74
434.41
257.05
954.40
734.16
151.78
116.76
89.81
69.09
53.14
105.08
80.83
62.18
47.83
72.75
55.96
43.05
50.36
38.74
34.87
If you plot the stock return and the probabilities of the returns after 10 years, you get a
graph such as the one below.1
The mathematics required to produce such a graph are too much for this book. For further details see my book
page 4
0.25
0.2
Probability
0.15
0.1
0.05
0
-100%
0%
100%
200%
300%
400%
500%
600%
700%
800%
900%
1000%
1100%
1200%
1300%
Return
A pedagogical note
Most finance books first discuss the binomial option model and then discuss BlackScholes. Their reasoning is that this order is logical because in principle the Black-Scholes
pricing formula can be derived from the binomial model. In this book weve reversed the order,
because we despair of telling you exactly how Black-Scholes is derived from the binomial.
Instead, weve treated the two models as entirely different topics with different pedagogical
goals: Black-Scholes is the most commonly used option pricing model; as a finance person you
should be familiar with this model and understand how to manipulate it (notice that we havent
said that you need to understand it!). The binomial model is more educational but less useful (at
least on the level of this book): It gives some insights into how options are priced through a
page 5
process of replication. It can also be used to understand topics such as the pricing of American
options and real options.
One of the uses we show for the binomial option pricing model is the use of the model to
price American options (section 26.4). These options cannot be priced using the Black-Scholes
formula, which prices only European options. In an advanced options course you will learn to
use the binomial option pricing model to price other, more complicated options.
Binomial model
Replicating portfolio
Max
Youre trying to calculate the value of a call option on ABC stock. The option
expires in one year and has an exercise price of $110.
page 6
ABC stock sells today for $100. A wise person has informed you that in one year, the
price of the stock will either be $130 or $90.2 We will refer to these possibilities as
the up and the down states.
The one-year interest rate is 6%. You can borrow or lend at this rate.
Heres a spreadsheet picture which incorporates all this information (the spreadsheet also shows
the payoffs on a put written on ABC stockwell get to that in a moment):
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
30%
-10%
100
6%
110
Bond price
130
<-- =$B$11*(1+B2)
100
1.06
<-- =$G$12*(1+$B$7)
1.06
<-- =$G$12*(1+$B$7)
1
90
<-- =$B$11*(1+B3)
Call payoff in
the "up" state
<-- =MAX(D10-$B$7,0)
???
<-- =MAX($B$7-D10,0)
20
<-- =MAX($B$7-D12,0)
???
0
<-- =MAX(D12-$B$7,0)
Call payoff in the
"down" state
Were going to price the call option by showing that there is a combination of the bonds
and stocks which gives exactly the same payoffs as the call option. To show this, we use some
basic high school algebra: Suppose we buy a portfolio of A shares of the stock and buy B bonds.
Then the payoff of the portfolio in the up state is 130 A + 1.06 B and the payoff of the portfolio
in the down state is 90 A + 1.06 B . Now lets find A and B so that these two payoffs equal the
call option payoffs:
This wise person forgot to tell you the probabilities attached to these 2 events, but it turns out not to matter.
page 7
130 A + 1.06 B = 20
90 A + 1.06 B = 0
130 A + 1.06 B = 20
90 A + 1.06 B = 0
20 0
0 90 A 90*0.5
A=
= 0.5, B =
=
= 42.4528
130 90
1.06
1.06
So now we know that buying half a share of ABC (cost: $50) and borrowing $42.4528
will give you payoffs in one year which are exactly the same as the payoffs of the call option.
The expenditure on this portfolio of {buy share, borrow $42.4528} should be the same as the
expenditure on the call option. Thus the call options price should be $7.5472:
call option price = 0.5*$100
.
$42.4528
= 7.5472
the financing
provided by
borrowing in the
"replicating
portfolio"
Option pricing in the binomial model is a wonderful example of the first two principles of
efficient markets discussed in Chapter 17. The first principle (Competitive markets have a
single price for a single good) implies that the combination of the stock + borrowing (which in
terms of payoffs has exactly the payoffs of the call option) should be priced like the call option.
The second principle, price additivity (The price of a bundle of securities should be the sum of
page 8
the prices of each of the securities) is also illustrated herethe price of the call option is the
cost of the stock ($45) minus the borrowing to finance this cost.
For option pricing theorists this method of pricing options is an example of arbitrage
the principle that if you can construct an assets payoffs in two ways, each of these ways should
have the same market value (which is, of course, Chapter 17s first principle of efficiency).
Summing it all up:
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
30%
-10%
100
6%
110
Bond price
130
<-- =$B$11*(1+B2)
100
1.06
<-- =$G$12*(1+$B$7)
1.06
<-- =$G$12*(1+$B$7)
1
90
<-- =$B$11*(1+B3)
Call payoff in
the "up" state
<-- =MAX(D10-$B$7,0)
???
<-- =MAX($B$7-D10,0)
20
<-- =MAX($B$7-D12,0)
???
0
<-- =MAX(D12-$B$7,0)
Call payoff in the
"down" state
We now use the binomial model to price a put on ABC with an exercise price of 110.
The put payoffs are shown above:
page 9
G
H
14
15
16 Put option payoffs
17
18
???
19
20
21
22
J
Put payoff in the
"up" state
<-- =MAX($B$7-D10,0)
20
<-- =MAX($B$7-D12,0)
Put payoff in the
"down" state
20
130 A 130 * ( 0.5)
= 0.5, B =
=
= 61.3208
130 90
1.06
1.06
The solution to the replicating portfolio indicates that short selling A = -0.5 shares and
investing in B = $61.3208 bonds gives the same payoffs as the put option. This means that the
price of the put is $11.3208:
put option price =
0.5*$100
+ $61.3208
= 11.3208
cash provided by
the short sale of
stock in the
"replicating
portfolio"
page 10
110
100 = 11.3208
1.06
30%
-10%
100
6%
110
Bond price
130
<-- =$B$11*(1+B2)
100
1.06
<-- =$G$12*(1+$B$7)
1.06
<-- =$G$12*(1+$B$7)
1
90
<-- =$B$11*(1+B3)
<-- =MAX(D10-$B$7,0)
???
<-- =MAX($B$7-D10,0)
20
<-- =MAX($B$7-D12,0)
???
0
<-- =MAX(D12-$B$7,0)
page 11
A call looks like a portfolio composed of the purchase of a stock and the short sale of a
bond. The calls replicating portfolio is
A * SUp + B * (1 + r ) = Call payoffUp
A * S Down + B * (1 + r ) = Call payoff Down
where:
SUp and S Down are the stock prices in the "up" and "down" states
Call payoffUp and Call payoff Down are the call payoffs
In terms of the calls replicating portfolio, it turns out that A (the stock) is always positive
and B (the bond) is always negative. This indicates the purchase of a stock financed by
borrowing. In a sense the Black-Scholes formula has the same property:
BS call price = S * N ( d1 ) Xe rT N ( d 2 )
Purchase of
stock
(positive number)
Borrowing at
the risk free rate
( negative number )
A put looks like a portfolio composed of the short sale of a stock and the purchase of a
bond. The puts replicating portfolio is:
A * SUp + B * (1 + r ) = Put payoffUp
A * S Down + B * (1 + r ) = Put payoff Down
where:
SUp and S Down are the stock prices in the "up" and "down" states
Put payoffUp and Put payoff Down are the put payoffs
In terms of the puts replicating portfolio, it turns out that A (the stock) is always negative
and B (the bond) is always positive. This indicates the purchase of bonds financed by a
short sale of the stock. In a sense the Black-Scholes formula has the same property:
BS put price = S * N ( d1 ) + Xe rT N ( d 2 )
Short sale of
stock
(negative number)
Investing at
the risk free rate
( positive number )
page 12
The probabilities of the up and the down states dont appear explicitly in the calculation
of the option price. To see what this means, look at the way we solved for the call option
price at the beginning of this chapter:
130 A + 1.06 B = 20
90 A + 1.06 B = 0
These equations solve to give:
20 0
0 90 A 90*0.5
A=
= 0.5, B =
=
= 42.4528
130 90
1.06
1.06
The resulting call option price:
call option price = 0.5*$100
$42.4528
= 7.5472
the financing
provided by
borrowing in the
"replicating
portfolio"
This calculation of the call option price when the option exercise price is $110 relies on 3
facts: i) The current stock price is $100, ii) The stock price next period is either 130 or
90, iii) The interest rate is 6%. Nowhere in this calculation have we made any reference
to the probabilities that the stock price will be $130 or $90.3
The binomial model is extendibleit can be used to price many options in a multiperiod
setting. In the next section we show a multi-period binomial model.
Of course you could quibble a bit and insist that the stock price today must incorporate these probabilities in some
sense, and youd be right. But even here you have to be carefulfor example, it would be wrong to say that the
stock price is the discounted expected future payoff of the stock. To explain this all would take us too far afield
suffice it to say that if investors are risk averse, theyll price the stock at below its expected future discounted
payoff. The amount of this discount depends on the risk aversion.
page 13
30%
-10%
100
6%
110
Stock price
Bond price
169.00
1.1236
130
100
1.06
117.00
90
Date 0
Date 1
1.1236
1.06
81.00
Date 2
Date 0
Date 1
1.1236
Date 2
<-- =MAX(E10-$B$7,0)
0.00
???-1
???-0
7.00
<-- =MAX(E12-$B$7,0)
0.00
Date 2
<-- =MAX(E14-$B$7,0)
???-0
???-2
Date 0
Date 1
<-- =MAX($B$7-E10,0)
???-1
0.00
<-- =MAX($B$7-E12,0)
29.00
Date 2
<-- =MAX($B$7-E14,0)
???-2
Date 0
Date 1
In this example, the stock price goes up by 30% or down by 10% in each period. Starting
with a stock price of $100 at Date 0, the stock price at Date 1 will be either $130 or $90, and the
stock price at Date 2 will be either $169, $117, or $81.
$169: This happens if it goes up twicethat is: 169 = 100* (1.30 )(1.30 )
$117: This happens if the stock price goes up once and down oncethat is:
117 = 100* (1.30 ) * ( 0.90 ) . Notice that it doesnt matter if the stock price goes up first
$81:
This happens if the stock price goes down twicethat is 81 = 100* ( 0.90 )( 0.90 ) .
In each period the risk-free interest rate is 6%, so that $1 invested in the bond will grow to
$1.1236 at date 2.
page 14
At the end of the second period, the options payoffs are given by
Max (169 110,0 ) = 59
We now have to value the option. We proceed by doing 3 valuationsthese are labeled in the
diagram as ???-1, ???-2, and ???-0. The put option has the same labelswell figure out
in a while how to price these.
We proceed as we did for the one-period binomial option pricing model. Setting up the
one-period stock and bond prices and option payoffs, we get:
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
A
B
Finding ???-1 for the call
Stock price
Bond price
169.00
130
1.1236
1.06
117.00
1.1236
Setting up the equations (we use A to denote the number of shares and B to denote the bonds in
the replicating portfolio):
page 15
169 A + 1.1236 B = 59
117 A + 1.1236 B = 7
Solution:
59-7
=1
169-117
7 117 * A
B=
= 97.8996
1.1236
A=
Again we proceed as we did for the one-period binomial option pricing model. Setting
up the one-period stock and bond prices and option payoffs, we get:
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
A
B
Finding ???-2 for the call
Stock price
Bond price
117.00
90
1.1236
1.06
81.00
1.1236
Once more we set up a simple binomial model, but this time we use the two values
derived abovethe prices of the call option at date 1.
page 16
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
A
B
Finding ???-0 for the call
Stock price
Bond price
130.00
1.0600
100
1
90.00
1.0600
As you can see from the diagram, the put has date 2 payoffs of:
G
H
18 Put option price
19
20
21
???-0
22
23
24 Date 0
0.00
<-- =MAX($B$7-E10,0)
0.00
<-- =MAX($B$7-E12,0)
29.00
Date 2
<-- =MAX($B$7-E14,0)
???-1
???-2
Date 1
We can use the same logic (and even the same equations) to price the put. The results,
shown below with no explanations) show that the put price at date 0 is 9.2916.
You probably suspect that theres a more efficient way to do this, and youre right. A good starting place is
page 17
A
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
Bond price
169.00
130
1.1236
1.06
117.00
1.1236
Bond price
117.00
90
1.1236
1.06
81.00
1.1236
Bond price
130.00
100
1.0600
1
90.00
1.0600
page 18
We can also use put-call parity to price the put. As discussed in Section 24.3 put-call
parity says:
Put price + Stock price = Call price + PV ( Exercise price )
135
136
137
138
139
140
110
(1.06 )
100 = 9.2916
A
B
C
D
E
Pricing the put with put-call parity
Initial stock price
100
Interest rate
6%
Exercise price
110
Call price
11.3919
Put price
9.2916 <-- =B139+B138/(1+B137)^2-B136
26.4. Advanced topic: Using the binomial model to price an American put
The binomial model is cute and easy to understand. But why do we need it? The answer
is complex and mostly beyond the scope of this book:
Whereas the Black-Scholes formula prices only European options, the binomial model
can be used to price American options. This use of the binomial model is illustrated in
the next sub-section.
Properly implemented, the binomial model can help us prove the Black-Scholes formula.
This use of the binomial model is too advanced for this book.
page 19
The binomial model can be used to price more complex options than those priced with
Black-Scholes, which prices only European options.
binomial model to price options where the exercise price changes over time, or where the
interest rate varies.
We can also use the binomial model to price options where the up and the down
movements of the stock price vary over time. Many finance people believe, for example,
that the volatility of the stock price return varies with the price itselfthat the percentage
up and the down movements for a stock are larger when the stock price is small.
This can be handled by the binomial model, but not by Black-Scholes.
page 20
On 29 January 2005 you buy an Asian call option on IBM with a maturity of one year.
The options payoff on 29 January 2006 is the difference between the average daily
closing IBM stock price in the 30 days preceding the options maturity and the options
exercise price X = $120. This option cannot be priced using the Black-Scholes model,
but it can be priced using the binomial model.
A barrier option is an option whose payoff depends on whether the stock price reaches a
On 29 January 2005 you buy a one-year knock-in barrier option on IBM, which is
currently selling at $93. The option specifies that you have the right to buy a share of
IBM on 29 January 2006, provided that at some point during the year IBMs stock price
exceeds $120 (this is the knock-in barrier. If the price of IBM during the coming year
does not exceed $120, your option is worthless. Barrier options cannot be priced using
the Black-Scholes model, but they can be priced using the binomial model.
There are many more of these weird options.
background is http://www.riskglossary.com .
page 21
To illustrate one more-sophisticated use of the binomial model, well show you how it
can be used to price an American option. Recall that American options can be exercised early.
We go back to our 2-date example and focus on the put price (highlighted):
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
30%
-10%
100
6%
110
Stock price
Bond price
169.00
1.1236
130
1.06
100
117.00
1.1236
90
1.06
81.00
1.1236
<-- =MAX(E10-$B$7,0)
???-1
0.00
<-- =MAX($B$7-E10,0)
0.00
<-- =MAX($B$7-E12,0)
29.00
<-- =MAX($B$7-E14,0)
???-1
???-0
7.00
<-- =MAX(E12-$B$7,0)
???-0
???-2
???-2
0.00
<-- =MAX(E14-$B$7,0)
Well price the put just as we did the call in the previous section. However, this time we
assume that the put is an American putmeaning that it can be exercised early.
We start by pricing the put at the up-state of date 1 (this is marked ???-1 in the
spreadsheet. This is actually fairly simple: at ???-1 the put owner has future payoffs of zero, no
matter what happens. This means that the put should be worth zero, and thats exactly what the
spreadsheet tells us:
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
A
Finding ???-1 for the put
Stock price
Bond price
169.00
130
1.1236
1.06
117.00
Put option price
0.00
???-1
0.00
The put replicating portfolio
Stock, A
Bonds, B
Put price ???-1
1.1236
There's actually no need to do
any calculations for ???-1: The
price ???-1 is the value of a
security which has zero payoffs
one period hence. By any logic
this price should be zero.
page 22
At ???-2 the situation is more complicated. The put has a future payoff which is positive.
We can use the binomial model to solve for the put price:
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
A
Finding ???-2 for the put
Stock price
Bond price
117.00
1.1236
90
1.06
81.00
1.1236
-0.8056
83.8822
16.4151
20.0000
<-- =(D50-D52)/(D45-D47)
<-- =(D52-B55*D47)/H45
<-- =B55*B46+B56*F46
<-- =MAX(B7-B46,B55*B46+B56*F46)
But now the early-exercise feature of the put comes in (rememberits an American
put). The put value of $16.4151 (cell B57 above) is the value of a put which has payoffs only
next period. Instead of waiting until next period, we can exercise the put today: The stock price
is $90 and the put exercise is $110, which means we can collect $20 immediately if we earlyexercise the put. So the actual put valuegiven the early-exercise featureis $20 and not
$16.4151 (cell B58):
Using this value of $20, we can price the put at date 0:
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
A
Finding ???-0
Stock price
Bond price
130.00
100
1.0600
1
90.00
1.0600
page 23
In Section 26.3 we priced a European put with the same exercise price X = $110. There
we concluded (page000) that the value of the European put is $9.2916. When we reprice the put
as an American put, we see that its price is $11.3208, higher than the European put price. This
happens because we will want to early-exercise the put at ???-2.
Conclusion
The binomial option pricing model can be used to price options under more general
conditions than those which hold for the Black-Scholes model. This chapter has revealed only
the tip of this financial iceberg, showing you how to implement the model in a 1-date and 2-date
framework. Weve also indicated how the model can be used to price American options and
weird options such as Asian options or barrier options.
page 24
Exercises
1. A stock selling for $25 today will, in one year, be worth either $35 or $20. If the interest rate
is 8%, what is the value today of a one-year call option on the stock with exercise price $30?
Use the simultaneous equation approach of section 14.1 to price the option.
2. In the exercise 1: Calculate the value today of a one-year put option on the stock with
exercise price $30. Show that put-call parity holds: That is, using your answer from this
problem and the previous problem, show that:
call price +
X
= stock price today + put price
1+ r
3. In a binomial model a put option is written on a stock selling today for $30. The exercise
price of the put option is 40. The put options payoffs are 20 and 5. The price of the put is
12.25. What is the riskless interest rate? Assume that the basic period is one year.
4. All reliable analysts agree that a share of ABC Corp., selling today for $50, will be priced at
either $65 or $45 one year from now. They further agree that the probabilities of these events
are 0.6 and 0.4 respectively. The market risk-free rate is 6%. What is the value of a call option
on ABC whose exercise price is $50 and which matures in one year?
5. A stock is currently selling for 60. The price of the stock at the end of the year is expected
either to increase by 25% or to decrease by 20%. The riskless interest rate is 5%. Calculate the
page 25
price of a European put on the stock with exercise price 55. Use the binomial option pricing
model.
35%
-5%
40
25%
40
state prices
qu
???
qd
???
Stock price
Bond price
???
???
???
40
???
???
???
???
???
???
???
???
???
???
???
???
???
???
???
???
???
???
???
???
???
7. Consider the following 2-period binomial model, in which the annual interest rate is 9% and
in which the stock price goes up by 15% per period or down by 10%:
Stock price
Bond price
66.1250
1.1881
57.50
50
1.09
51.7500
45.00
1.1881
1.09
40.5000
1.1881
page 26
In each period the stock price either goes up by 30% or decreases by 10%.
Stock price
Bond price
50.70
1.5625
39.00
30
1.25
35.10
1.5625
27.00
1.25
24.30
1.5625
a. Consider a European call with X = 30 and T = 2. Fill in the blanks in the tree:
Call option price
???
???
???
???
???
???
???
???
???
9. A prominent securities firm recently introduced a new financial product. This product, called
The Best of Both Worlds (BOBOW for short), costs $10. It matures in 5 years, at which point
page 27
it repays the investor the $10 cost plus 120% of any positive return in the S&P500 index. There
are no payments before maturity.
For example: If the S&P500 is currently at 1500, and if it is at 1800 in 5 years, a
BOBOW owner will receive back $12.40 = $10*[1 + 1.2*(1800/1500-1)]. If the S&P is at or
below 1500 in 5 years, the BOBOW owner will receive back $10.
Suppose that the annual interest rate on a 5 year, continuously compounded, purediscount bond is 6%. Suppose further that The S&P500 is currently at 1500 and that you believe
that in 5 years it will be at either 2500 or 1200. Use the binomial option pricing model to show
that BOBOWs are worth more than their current price of $10.
10. A call option is written on a stock whose current price is $50. The option has maturity of 2
years, and during this time the annual stock price is expected to increase by 25% or to decrease
by 10%. The annual interest rate is constant at 6%. The option is exercisable at date 1 at a
price of $55 and at date 2 for a price of $60. What is its value today? Will you ever exercise the
option early?
11. A stock is currently selling for 60. A Put option has maturity of 2 years, and during this
time the annual stock price is expected to increase by 30% or to decrease by 10%. The riskless
interest annual rate is 6%. The put option is currently selling for $9. Is the option more likely an
American or a European put option? Use the binomial option pricing model to determine.
12. A call option is written on a stock whose current price is $100. The option has maturity of 2
years, and during this time the annual stock price is expected to increase by 30% or to decrease
page 28
by 10%. The annual interest rate is constant at 6%. The options exercise price is $110. Extend
the Binomial Option Pricing to incorporate a $3.00/share dividend that will be paid out in
period 2. In other words, all of the period 2 stock prices will be reduced by $3.00. Determine the
current prices of the call. Compare to the non-dividend case that is appears in Chapter 26.
13. A 2-years American put option is written on a stock whose current price is 42. You expect
that in each year the stock price either goes up by 10% or decreases by 5%. The one-period
interest rate is 5%. The options exercise price is 45.
Will you ever exercise the option early? Refer to Fact 6 of Chapter 21.
page 29