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Concept Problem) The binomial model can be used to price unusual features of options. Consider the following scenario. A stock priced at $75 can go up by 20 percent or down by 10 percent per period for three periods. The risk-free rate is 8 percent. A European call option expiring in three periods has an exercise price of $70. The parties to the option agree, however, that the maximum payout of this option is $40. Find the current value of the option. Then determine whether an American version of the option, also limited to a maximum payout of $40, would have any additional value over the European version. Compare your answers to the value of the option if there were no limitation on the payoff
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Using the information in the previous question, consider a proposal to price the exports to Mexico in U.S. dollars and use the U. S. source for raw materials. Would this proposal eliminate the exchange rate risk? Why or why not?
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