8. Assume that
the periodic risk free rate is 5%.
(a) Construct a 2 period binomial tree on ABC’s stock.
(b) What is the value of a call option on ABC’s stock with an exercise
price equal to
e
180 maturing after 2 periods?
(c) CBOT (Chicago Board of Trade) is also offering a new exotic
Down-and-Out call option for ABC. This option matures after 2
periods and has an exercise price equal to
e
180. The difference is,
however, that a Down-and-Out option immediately expires (be-
comes worthless) if the share price drops below some predefined
level, in this case
e
185. What is the value of this Down-and-Out
option today?
3. XYZs stock price is today
e
80. Its volatility is 37% p.a. The annually
compounded risk free rate is 3%.
(a) Construct a two period binomial model to value a European call
option with exercise price of
e
85 that matures two years from
now.
1

(b) You notice that the two year call with exercise price
e
85 is trading
at
e
13. Is there an arbitrage opportunity? If no, explain why not.

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