1.)A stock price is currently $100. Over each of the next two six month periods
ID: 2792269 • Letter: 1
Question
1.)A stock price is currently $100. Over each of the next two six month periods it is expected to go up by 10% or down by 10%. The risk free interest rate is 8% per annum with contunous compounding. What is the value of a one year European call option with a strike price of $100.
2.)For the situation above what is the value of a one year European put option with a strike price of $100. Verify that the European call and European put prices satisfy put-call parity.
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Explanation / Answer
As per given question
u = 1.1
d = .9
r = .08
t = .5
T = 1, and K = 100.
So Risk neutral probability = e^r*t - d/(u-d)
p = e (.08)(.5) (.9)/ 1.1 .9 = .7041 and 1 p = .2959.
The value of the call option is therefore f = e ^(.08)(1)[(.7041)^2 (21)+(.7041)(.2959)(0)+(.2959)^2 )(0)] = $9.61.
value of put option = e ^(.08)(1)[(.7041)^2 (0)+(.7041)(.2959)(1)+(.2959)^2 )(19)] = $ 1.92
For put call parity
Call option price + pv of strike price = put option price + spot price
LHS = 9.61 + 100*e^-.08 = 101.92
RHS = 1.92 + 100 = 101.92
hence proved
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