Figure 1:

M2. We can approximate the pdf of ST on the following intervals:

[0, 80], [80, 85], ..., [115, 120], [120, +∞)
The resulting probabilities are given in the figure above:

The price would then be P (ST > 100) = P (ST ∈ [100, 105] ∪ [105, 110] ∪
[110, 115] ∪ [115, 120] ∪ [120, +∞]) = 0.4960

M3.
Methodology:

The classical Black Scholes model assumes that the implied volatility is
constant, which is not the case here anymore.

So what should we use instead?

We can still use the Black Scholes model but with an adjustment. Write
c(T, K; (.)) = c(T, K, σ(T, K); (.)) where (.) means the other parameters.

In a flat-smile model, the digital option price can be written as cdig

BS =
c(K−,T )−c(K,T ) −rT −rT
lim→0 
= −∇c (K, T ) = e N (d2 ) = e P (ST > K) (As a
matter of fact we have chosen to price a digital call option by using an  -