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Binomial Model for Put Options

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A stock is worth \$40 today. In the next six months it may increase to \$46 or decrease to \$35. The risk-free rate of interest is 4% per year. Use the binomial model to determine the price of a put option with a strike price of \$40 and an expiration date in six months. Please show your work and choose from the answer choices below:

a. 3.62

b. 1.85

c. 2.32

d. 3.10

e. 2.50

Solution Preview

Our strategy is to replicate the payoff of the put option using a combination of the stock and borrowing at the risk-free rate. The price of this replicating portfolio is the price of the put option.

Let's say you borrow \$x from the bank ...

Solution Summary

This solution provides a step-by-step explanation of how to use the binomial model to determine the price of a put option.

\$2.49