3- Binomial Option Pricing Model

Question 1

what type of option is best priced using binomial option pricing?

Answer 1

US options

Question 2

can a portfolio be hedged (made riskless) using options and stocks?

Answer 2

yes, need to buy “h” shares and long/short a call

Question 3

what does hedged mean?

Answer 3

V up = V down

Question 4

to hedge when shorting stock what position should you take in call/put?

Answer 4

• long call

- short put

Question 5

to hedge when holding stock what position should you take in call/put?

Answer 5

• short call

- long put

Question 6

what happens when a call is overpriced in the market, and you are shorting calls? how does the market react?

Answer 6

everyone would short calls, take advantage of higher gain, force price to converge§

Question 7

what should you do if a call is under priced in a two period binomial model?

Answer 7

buy call short stock

Question 8

what should you do if a call is over priced in a two period binomial model?

Answer 8

sell call buy stock

Question 9

what is the maximum value of a EU put and a US put?

Answer 9

EU = PV (X)
US = X

Question 10

how do you incorporate dividend payments in multi period binomial trees?

Answer 10

subtract PV of dividend from the stock price at time zero

Question 11

when do you exercise an american call in a multi period binomial tree?

Answer 11

at the time period when the call has the greatest value