Reference no: EM133076580

A. Volatility is an important input in option valuation, but it is not an observed variable and must be estimated. It can be estimated using historical data. Alternatively, since option prices can be observed, we can use the observed option price together with other market data to imply volatility. This volatility can then be used to value other options. Suppose a European call option written on the Russell 2000 index with an exercise price of 2,250 and a time-to-maturity of 12 months is currently trading at $254.525. The interest rate and dividend yield are 2.5% and 2.05% respectively (both continuously compounded). The current index level is 2,300. Use a three-step tree to imply the volatility. (Hint: set up the tree in a spreadsheet and find the implied volatility by Solver.)

B. In the same set-up as above, suppose everything remains the same except that someone has already estimated the volatility to be 25%, and the European call is worth $274.482. What is the implied dividend yield?