Binomial Option Pricing Model
Chapter 22 Problem 1 pg 841You are considering the sale of a call option with an exercise price of $100 and one year to expiration. The underlying stock pays no dividends, its current price is $100, and you believe it will either increase to $120 or decrease to $80. The risk-free rate of interest is 10 percent.a.Describe the specific steps involved in applying the binomial option pricing model to calculate the option’s value.b.Compare the binomial option pricing model to the Black-Scholes option pricing model.
Donna Donie, CFA, has a client who believes the common stock price of TRT Materials (currently $58 per share) could move substantially in either direction in reaction to an expected court decision involving the company. The client currently owns no TRT shares but asks Donie for advice about implementing a strange strategy to capitalize on the possible stock price movement. Donie gathers the TRT option pricing data shown in the following table:
TRT Materials Option Pricing Data (USD)
Time to expiration
90 Days from now
90 Days from now
a. Recommend whether Donie should choose a long strangle strategy or a short strangle strategy to achieve the client’s objective. Justify your recommendation with ONE reason.
b. Indicate at expiration for the appropriate strangle strategy in Part a, the :
1 Maximum possible loss per share
2 Maximum possible gain per share
3 Breakeven stock price(s)
Note: Your responses should ignore taxes and transaction costs.
The delta of the call option is 0.625 and TRT common stock does not pay any dividends.
c. Calculate the appropriate change in price for the call option if TRT’s stock price immediately increases to $59.