what is the process to calculate the payoff in both states?

Expert Solution

The process to calculate the payoff in both the states are quite simple. You have to apply the criteria and calculate the payoff in light of what has happened in each state.

Let me explain this by way of an example. Let's say we have a call option on a stock S with strike price of $ 100. Current stock price is $ 110. Next year when the European call option is expiring, the stock price can assume two states: An up state where price can be u = 1.20 times the current price or a down state where price can be d = 0.80 times the current price.

S₀ = $ 110

K = $ 100

S_u = stock price in up state = u.S₀ = 1.2 x 110 = $ 132

S_d = stock price in down state = d.S₀ = 0.8 x $ 110 = $ 88

Hence payoff from Call option in up state = max (S_u - K, 0) = max (132 - 100, 0) = $ 32

Payoff from call option in down state = max (S_d - K, 0) = max ( 88 - 100, 0) = 0

Thus we have calculated the payoff in each of the two states. I really hope this example helps you understand the process to calculate the payoff in both states.

jeff jeffy answered 1 year ago

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