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5.The current price of a non-dividend-paying stock is $40. Over the next year it is expected to rise to $42 or fall to $37. An investor buys put options with a strike price of $41. What is the value of each option? The risk-free interest rate is 2% per annum with continuous compounding.

A.$3.93

B.$2.93

C.$1.93

D.$0.93

A.$3.93

B.$2.93

C.$1.93

D.$0.93

Answer: D

The formula for the risk-neutral probability of an up movement is

In this case r=0.02, T= 1, u=42/40=1.05 and d=37/40=0.925 so that p=0.76 and the value of the option is (0.76×0+0.24×4)e-0.02×1=0.93

The formula for the risk-neutral probability of an up movement is

In this case r=0.02, T= 1, u=42/40=1.05 and d=37/40=0.925 so that p=0.76 and the value of the option is (0.76×0+0.24×4)e-0.02×1=0.93

Flashcard info:

Author: CoboCards-User

Main topic: Finance & Investment

Topic: Derivatives

Published: 27.10.2015