Question

Compute the price of a European call option using the two period binomial model assuming the following data:
S0 = 10, T = 2 months, u = 1.5, d = 0.5, r = 0.05, K = 7, D=0. Show all the steps

Answer 1

Given,

StrikePrice (S₀) = 10

Time Period (T) = 2 months

Increasing Factor (u) = 1.5

Decreasing Factor (d) = 0.5

Risk Free Return (r) = 0.05

Strike Price (K) = 7

First Let's find out the Probabilities of Increasing and Decreasing

Take case of S_ud, here price goes to 7.5, as it is greater than Strike Price (K=7), we exercise Call Option.

Option of Call Value at S_ud (C_ud) = 7.5 - 7 = 0.5

Take case of S_du, here price goes to 7.5, as it is greater than Strike Price (K=7), we exercise Call Option.

Option of Call Value at S_du(C_du) = 7.5 - 7 = 0.5

Take case of S_dd, here price goes to 2.5, as it is less than Strike Price (K=7), we forgo Call Option.

Option of Call Value at S_dd (C_dd) = 0