(a) Consider a two year put option with a strike price of shs 52 on a stock whose current price is sh 50. Suppose there are two time steps of one year each and in each step, the stock price moves up by 20% or down by 20%. The risk free rate is 5%.
Calculate the value of the put using Binomial model (Assume it is a European option). [6 marks]
(b) An investor is interested in buying a call option on ABC Ltd, a non-dividend paying common stock with a strike price of shs.100 and 6 months until expiration. ABC stock is currently trading at shs 90 per share and the annual variance of its continuously compounded returns is 25%. The treasury bills that mature in 6 months yield continuously compound interest of 10% p.a.
Required:
(i) Use black scholes model to calculate the price of the call option that the investor is interested in buying. [6 marks]
(ii) If an investor wants to buy a put with the same exercise price and expiration date as the call option what will be the value of the put (Apply put-call-parity relationship. [2 marks]
(c) Based on the risk and return relationships of the CAPM, supply values for the seven missing data are the following table.
Security Expected return % Beta Standard deviation Non-Market risk
s^2 e_i
A – 0.8 – 85
B 19.0 1.5 – 0.49
C 15.0 – 8 0
D 7.0 0 12 –
E 21.0 – 15 –
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