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Shares in Winnie Corp are currently trading at $10. The company is about to pay a dividend of $2 a share and the share price will then decline to $8. Over the subsequent quarter, the share price will either rise by 35% or decline by 25%. Note that the share price will go up or down only once over the coming quarter. The continuously compounded risk-free rate is 8% per annum. Consider a three-month European put option on a share of Winnie Corp with an exercise price of $10.50.
(a) What are the two possible values of a Winnie Corp share at the end of the quarter?
(b) What positions in Winnie Corp stock and bonds will replicate the payoff to this put and what is the cost of the replicating portfolio?
(c) Check your valuation using the risk-neutral pricing technique.
(d) What would be the price of the put if it were an American-style option?
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