Hannes Messer Case

Messer replies, “The binomial valuation model can be applied to the two-year European style index call options we purchased one year ago. The applicable underlying instrument is the German Blue Chip Equity price index, which excludes dividends. Exhibit 1 shows the option’s characteristics at the time of purchase.”

EXHIBIT 1

BINOMIAL MODEL VARIABLES

u

1.15

d

0.90

π

0.52

Index price

EUR 720

Strike price

EUR 750

Hedge ratio

.5697

1-year interest rate

3%

S

648

C

0

Q. Using the binomial valuation method and the data in Exhibit 1, the price Messer paid one year ago for the call option with a strike price of EUR750 is closest to:

  1. EUR51.54.
  2. EUR47.57.
  3. EUR102.08.

Is it A?

c++ = Max(0, u2S - X)

= Max(0, 1.152 * 720 - 750)

= 202.2

c-+ = Max(0, udS - X)

= Max(0, 1.15 * 0.90 * 720 - 750)

= 0

c = Max(0, d2S - X)

= Max(0, 0.902 * 720 - 750)

= 0

c = PV[π2 c++ + 2π(1 - π) c-+ + (1 - π)2 c]

= [1/(1 + 0.03)]2 [(0.522)(202.2) + (2)(0.52)(1 - 0.52)(0) + (1 - 0.52)2(0)]

= 51.54

Yes thanks.

I would humbly suggest to solve such ques using tree structure…