Reference no: EM132681594

Setup:Assume that the stock price for XYZ Corp follows a binomial lattice

Assume the lattice has a multiplicative structure and

- The stock either moves up by multiple u = 5/4 or down by a multiple d = 1/u = 4/5

- The stock moves up or down with equal probability

- Let S0=10 denote the initial value of the stock and Sn its value after n-steps

There is also a risk free asset available with rf = 0

(a): For a one-period model (i.e. S0 → S1), find the state prices ψu and ψd as well as the risk-neutral probabilities qu and qd.

(b): Compare the objective probabilities (i.e. 50% up or down) with the risk-neutral probabilities found in (a). Are they the same or different? Why?

(c): Draw the lattice for two periods.

(d): Price a European put option with expiry n = 2 and strike K = $8.40.