3. Forward start option.

The risk-neutral probability that the rst branch is up is erT0 d p1 = ud and for the second period it is p2 = er(T1 T0 ) d . ud

Write qi = 1 pi , i = 1, 2. The paths and payos (assuming the option to be a call) are: Path uu ud du dd Probability p 1 p2 p 1 q2 q 1 p2 q 1 q2 Strike S0 u S0 u S0 d S0 d Payo S0 u2 S0 u 0 S0 du S0 d 0

Note that the payos depend on the path, so we cannot write this as a recombining tree. The fair value is V0 = erT1 S0 [p1 p2 u(u 1) + q1 p2 d(u 1)] = erT1 S0 (u 1)p2 [p1 u + q1 d] = er(T1 T0 ) S0 (u 1)p2 . 4. Digital option. At each step, the risk-neutral probability of up is p= e r t d . ud

At time T there have been N = T /t steps; if L of these were up, ST = S0 uL dN L . The probability of a payo is
N

P[ST > K ] =
l=0

1S0 ul dN l >K (l)P[L = l]

and the fair price is XerT times this probability. 1

More explicitly, ST = S0 uL dN L L = so P[ST > K ] = P L > l = ln(ST /S0 ) N ln d ln u ln d ln(K/S0 ) N ln d ln u ln d

where L has the binomial distribution Bin(N, p). So the fair price is
N

Xe

rT

P[ST > K ] = Xe

rT l= l

N l p (1 p)N l . l

5. American call. The value Ct of an American call is no less than the value CtEuropean of the corresponding European call. Put-call parity states that CtEuropean = PtEuropean + St Ker(T t) St Ker(T t) so Ct CtEuropean St Ker(T t) . So for 0 t < T , because r > 0, Ct St Ker(T t) > St K. But St K is the net result of exercising the call at time t, and since this is strictly less than Ct , the option is worth more when it is not exercised. 6. American put. Suppose that at some time t, Ct + K < Pt + St ; then an arbitrage exists: sell short one share; sell one put; buy one call.

This produces a net cash ow of St + Pt Ct > K , which is invested at the risk-free rate. If the put is exercised, the invested cash is more than enough to pay the strike K , and the delivered share can be used to close out the short sale. Even ignoring the value of the call, the arbitrageur is in the money. If the put is not exercised, at maturity the invested cash is more than enough to exercise the call, using the purchased share to close out the short position. So either way, the arbitrageur is in the money. If no arbitrage exists, therefore, we must have Ct + K Pt + St . Since the American put is worth at least as much as the European put, and the American call is worth the same as the European call, put-call parity implies that Pt + St PtEuropean + St = Ct + Ker(T t) . The combination of these inequalities gives St K Ct Pt St Ker(T t) , and if r = 0, Pt = Ct + Ker(T t) St = PtEuropean ; that is, the American put has the same value as the European put, so the opportunity for early exercise adds no value. 8. Dividends All branches are 20, so every risk-neutral branch probabil1 . After the dividend, the three values at t = 2 are 140 0.95 = ity is 2 133, 100 0.95 = 95, and 60 0.95 = 57. The six values at t = 3 are therefore 153, 113, 115, 75, 77, and 37. If the call is not exercised before t = 3, the payos are 53, 13, 15, 0, 0, and 0. The values at t = 2, again assuming no exercise, are therefore 33, 7 1 , and 0. 2 At the t = 2 node where the price is 140 before the dividend, early exercise gives the payo 40, whereas the value if not exercised is 33, so early exercise is optimal at this node.
3 The values at t = 1 are therefore 23 3 and 3 4 , in each case higher than 4 the value if exercised (20 and 0, respectively). So exercise at t = 1 is . suboptimal, and the value at t = 0 is 13 3 4