CHAPTER 21

1thenthevalueoftheeuropeanputis

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Unformatted text preview: opean, it would not be possible to exercise early. Therefore, if the price rises to $440 at month 6, the value of the option is $265, not $275 as is the case for the American option. Therefore, in this case, the value of the European option is less than the value of the American option. The value of the European option is computed as follows: 8. The following tree (see Practice Question 5) shows stock prices, with the values for the one­year option values in parentheses: The put option is worth $55 in month 6 if the stock price falls and $0 if the stock price rises. Thus, with a 6­month stock price of $110, it pays to exercise the put (value = $55). With a price in month 6 of $440, the investor would not exercise the put since it would cost $275 to exercise. The value of the option in month 6, if it is not exercised, is determined as follows: Therefore, the month 0 value of the option is: 9. a. The following tree shows stock prices (with put option values in parentheses): Let p equal the probability that the stock price will rise. Then, for a risk­neutral investor: (p ´ 0.111) + (1 ­ p)´(­0.10) = 0.05 p = 0.71 If the stock price in month 6 is C$111.1, then the...
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