# L5v-1 - The Setup: Three Period Binomial Model ECON...

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ECON 3107/5106 Lecture 5: Options Valentyn Panchenko The Setup: Three Period Binomial Model ° Two-period zero-coupon bond with initial value of \$1.00. Its price increases 5% of its prior value in every period. ° The Stock pays no dividends. Its initial value is \$1.00. ° Its price increases 26% of its prior value in good times. ° Its price falls to 96% of its prior value in bad times. Stock ✟✯ 1.00 ❍❥ g ✏✶ 1.26 ° ° ° ° °± b ✏✶ 0.96 ° ° ° ° °± gg 1.5876 gb 1.2096 bg 1.2096 bb 0.9216 Example: European Call Option Consider a European Call option that gives the holder a right to buy the Stock at Period 2 at the Exercise Price, X = 1.10. Pricing a European Call Option The cash Fow associated with the call option: c = 0 0 0.4876 0.1096 0.1096 0 g b gg gb bg bb The atomic prices are still the same: g b gg gb bg bb p atom = ° 0.2857 0.6666 0.0816 0.1904 0.1904 0.4444 ± The value of the call option is: p call = p atom · c = 0.0816

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Example: European Put Option Consider a European Put option that gives the holder a right to sell the Stock at Period 2 at the Exercise Price, X = 1.20. Pricing a European Put Option The cash fow associated with the put option: c = 0 0 0 0 0 0.2784 g b gg gb bg bb
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## This note was uploaded on 07/13/2011 for the course ECON 3107 at University of New South Wales.

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L5v-1 - The Setup: Three Period Binomial Model ECON...

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