Now S1 S2 one year 46.31 44.10 42.00 42.34 40 40.32 38.40 38.71 36.86 35.39 a. I

Question

Now S1 S2 one year 46.31 44.10 42.00 42.34 40 40.32 38.40 38.71 36.86 35.39 a. If the sequence of stock prices that DEW stock follows over the year is $40.00, $42.00, $40.32, and $38.71, describe the composition of the initial riskless portfolio of stock and options you would form and all the subsequent adjustment you would have to make to keep this portfolio riskless. Assume the one year risk free rate is 6%. b. Given the initial DEW price of $40, what are the probabilities of observing each of the four terminal stock prices in one year? (Hint: In arriving at your answer, it will be useful to consider (1) the number of different ways that a particular terminal price could be achieved and (2) the probability of an up or down movement.) c. Use the binomial option model to calculate the present value of this call option. d. Calculate the value of a one-year put option on DEW stock having an exercise price of $38; be sure your answer is consistent with the correct response to part c.

Explanation / Answer

Sn=n^2 Stages 1, 2, and 3 of the shaded squares below... S1=1^2 = 1 S2=2^2 = 4 S3=3^2 = 9 Stage 12 of the shaded squares below... S12=12^2=144 shaded squares Understand? Now for the white squares... The white squares form an "arithmetic sequence." All you have to do is take the 1st term and "add" 4 to it each time. Stage 1: white squares is 8 so then add 4 to that and you get Stage 2: which is 12. So, it's basically 8+4=12, 12+4=16, and so on...

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