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