Consider a multiplicative binomial model with N = 3, r = 0, u = 1.2, d...

Consider a multiplicative binomial model with N = 3, r = 0, u = 1.2, d = 0.8 and S 0 = 100. At time t = 1 when S 1 = 120 a (european) call option with maturity at T = 3 and struck at 100 is quoted at 25. Is that a fair value? If yes explain why? If not explain why and explicitly deﬁne an arbitrage strategy (you have to give details of the arbitrage strategy)

Expert Solution

ANSWER IN THE IMAGE ((ORANGE HIGHLIGHTED). FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

Actual value of call option = 25
Should be value of call option = 25.80 (orange highlighted).

Since call(Actual) is trading at a discount compared to should be, Buy it.

Strategy for Arbitrage is:

Buy Call at t=1.
Buy Risk free asset.
Sell put at t=1.
Sell Stock at t=1.

jeff jeffy answered 1 year ago

Consider a multiplicative binomial model with N = 3, r = 0, u = 1.2, d...

Consider a multiplicative binomial model with N = 3, r = 0, u = 1.2, d = 0.8 and S 0 = 100. At time t = 1 when S 1 = 120 a (european) call option with maturity at T = 3 and struck at 100 is quoted at 25. Is that a fair value? If yes explain why? If not explain why and explicitly deﬁne an arbitrage strategy (you have to give details of the arbitrage strategy)

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Consider a multiplicative binomial model with N = 3, r = 0, u = 1.2, d...

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