A call has a strike of $21. At expiry, the underlying asset of this call is expected to be either $34 or $18

A call has a strike of $21. At expiry, the underlying asset of this call is expected to be either $34 or $18. Use the one-step binomial pricing model to calculate the premium of this call when the return is 1.04 and the upstate risk-neutral probability is 0.43.
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Expert Solution

Options contracts are part of derivatives contracts based on an underlying asset such as currency, commodity, stock, etc.

Derivatives contracts are entered between two parties to be settled at a future date and at a future price. Options contracts, forward contracts, interest rate swaps, futures contracts, etc. are all part of derivatives contracts.

Computation of the payoff

Cu = Price at upper level − Strike price

= $34 − $21

= $13

Cd = 0

The call value at the upper level (Cu) is calculated by reducing the strike price from the price at the upper level. The call value at the lower level is zero (Cd) because the option is exercised only in the case of profit. It is exercised when the strike price is less than the price of the future. The option holder gets the right in exchange for the premium.

Computation of the premium

By applying the concepts of derivatives contracts, the premium of the call can be determined. In derivatives contracts, a contract is entered between two parties settled at a future date and at a future price for various purposes such as hedging, speculation, etc. It can be used to determine the premium of the call option.

Computation of the payoff $13.

Junaid answered 2 years ago

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