Question

I have a question regarding the Calculate the call and put premiums for the following two-period situation, using the parameters provided in mapping out the binomial tree question. So to find Cu, Pu. I used the excel function to figure out the maximum value ( = max(0,120-105) ). Since we won't be allowed to use excel during the test. I wanted to know how I could calculate it using my financial calculator or any other way to calculate it without the use of excel.

Answer 1

Let us first understand what are Call and Put Options.

Call Option - It gives the right to the buyer to purchase a stock or an asset and not the obligation.

Put Option - It gives the right to the buyer to sell a stock or an asset and not the obligation.

What is a Put/Call Premium?

It is the amount given by the buyer of the call and put option to the seller of the call and put option. The amount paid gives the buyer the right to buy and not the obligation to buy an asset.

Equation of Call Option: Equation of Put Option

Max (0, So - X) Max (0, X - So)

Let us try to understand this through an example:

Assume, ABC is a stock, currently priced at $50 and you did your analysis and are convinced that the stock is going to rise to $80 in coming months. However, on the other side some analyst believes that the stock is not going to increase and is bearish. Now, in order to gain both of you enter into a contract where you buy the stock on the designated market by paying a Premium of $5 and the counter party gets that Premium of $5. Now, if the price rises above $55, you are in the money. You start earning profit every time the stock goes beyond $55 as you paid $5 as premium is cost for you as well.

Max (0, 80 - 50) = $30 - $5 = $25 - This is the profit you earned. Here, $80 becomes your stock price and $50 becomes your strike price.

Let me know if you need more clarification on the same.