Assignment 5 Topics: Binomial Model for European and American Options) 1.

One period Binomial Model: Assume that both H and T have positive probability of occurring. Assume also that 0<d<1+r<u holds. Then show that: if Xo = 0 and X1 = oS1 + (1+r) (Xo - oS0), then: we cannot have X1 strictly positive with positive probability unless X1 is strictly negative with positive probability as well, and this is the case regardless of the choice of the number o. (Thus starting with zero money, we cannot have a riskless positive value of our portfolio) 2. Asian Option: Consider the three period model with So = 4, u = 2, d = , r = (thus implying q = ). For 0n3, define . Consider an asian call option that expires at time 3, has K = 4 (pay off of such an option at time n, for example, is max(Yn/(n+1) 4, 0), it is thus a path dependent option. The European call option is on the stock price, Asian call option is on the average of stock price along path). Let vn(s,y) denote the option price at time n for Sn = s, Yn = y. In particular, v3(s,y) = max(y/4-4, 0). a) Write a formula for vn in terms of vn+1 (i.e. Develop an algo for computing vn recursively). b) Apply the algo in part a to compute vo(4,4). 3. American Call: Consider a 3 period binomial model with S0 = 4, u = 2, d = , r = , K = 4. Determine the price at time 0 of an American call option (payoff h(s) = max(s-4, 0)) that expires at time 3. 4. Consider the 3 period binomial model of problem 3 above. Find the time zero price and optimal stopping time for the path-dependent American derivative security whose payoff at each time n, n = 0,1,2,3 is max( , 0). This payoff is a put on the average stock price between time zero and time n.