Consider an n=1 step binomial tree with T=.5. Suppose r, the annualized risk-free rate is...
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Consider an n=1 step binomial tree with T=.5. Suppose r, the annualized risk-free rate is 6%, and delta, the annualized dividend rate is 5%. Also suppose the annualized standard deviation of the continuously compounded stock return, sigma, is 20%. Suppose further that the initial stock price, S=$85; and that the strike price K is $74. Suppose you observe a put price of $0.67, which is lower than the price for the European put option that you computed using the binomial tree method. By using the arbitrage method outlined in the book, that is, selling a synthetic put option and buying the actual put option: a) Determine the European put premium b) Determine the number of shares of stock that you'll buy ? c) Determine the amount of money that you'll borrow d) Determine the risk free profit from this arbitrage opportunity
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