Show the binomial tree for the CALL and PUT options providing their prices at each node

of the tree
In order to calculate the call and put option price at each level first the stock price was calculated at each level by simply Multiplying the stock price with u to get the first period upward movement and by d to get the 1st period downward movement The second period movement for the stock was calculated in the same way.

To calculate the call and put option price I worked backwards from the second movement to the initial price of the call and put option. Call Option The second period prices for call option was calculated by using the excel functions The maximum value between the second period upward price of the stock minus the strike price or zero if negative. Similar method was used to calculate the rest of the values in the second period of the call option price.

To calculate the first period option price first the probability of the option price to either go or up was calculated by using the below formula: ( )

For the first period upward movement of an option price the below formula was used ( )

For the first period downward movement the formula was ( )

Finally the formula for the initial option price ( )

While using these formulas where it says Cu and Cd the next possible movement was used to calculate the price.

Put Option The second period prices for call option was calculated by using the excel functions The maximum value between the strike price minus the second period upward movement or zero if negative. Similar method was used to calculate the rest of the values in the second period of the call option price.

To calculate the rest of the put option similar formulas were used as Call Option but instead of Cu and Cd it was Pu and Pd.

Show the hedge outcome for a call option at each node of the tree.
In this part of the question the main purpose was to hedge the risk of 0.8% downward movement in the interest rate. To achieve the best possible hedge at initial, first and second period following step were taken. To hedge first the hedge ratio was calculated at three levels by using the following formula ( )

INITIAL STAGE The stock was sold at the option price times the m(1) and it was bought back same way to get the final price of 100. S SellmC Buy B Stock price Option price x m1 Bought back at same price

FIRST PERIOD UPWARD Then Buy S Sell mC Buy B Buy Stock at 1.15 Sell Call option at Option price of period 1 Buy back the difference between Pay mC, SellB and BuyB. Sell S Pay mC Sell B Stock price x upward movement Pay Call Option Period 1 x m1 Earn the interest on the bought back stock

FIRST PERIOD DOWNWARD Sell S Pay mC Sell B Sell Stock at 0.8% Paid call option at downward movement of period 1 Earn the interest on the bought back stock

Then Buy S Sell mC Buy B Buy Stock at 0.8% Sell Call option at Option price of period 1 downward Buy back the difference between Pay mC, SellB and BuyB.

The similar method was used to calculate the second period of the binomial tree and it has been shown below.

Write a short report comparing the results obtained in parts A and B, and critically analyse the binomial model as a tool for hedging your portfolio (highlight the pros and cons of the model).
The key difference between the result obtained in part A and B is the fact that in part A the strike price was equal to the stock price which means that in the first period the call option was out of the money and we could not hedge the risk at that point because most values were either negative or very close to zero. But in Part B when the strike price was different than stock price we did manage to hedge the risk in each period of the binomial model and the outcome has been mentioned above. The Binomial Model The most commonly used lattice-based model of option pricing. Unlike the black-Scholes option pricing model (OPM), the binomial method divides the time from the option's grant date to the expiration date into small increments. Because the share price may increase or decrease during any interval, the binomial model takes into account how changes in price over the term of the option would affect the holder's exercise practice during each interval. The binomial model can also consider an option grant's lack of transferability, its forfeiture restrictions, and its vesting restrictions-even for options with more complicated terms such as indexed and performance- based vesting restrictions. The binomial model assumes the value of a call should be the expectation, in a risk-neutral world, of the discounted value of the payoff it will receive. As the time to expiration is divided into more intervals the above diagrams take on a lattice framework. If the time to expiration continues to be divided into smaller intervals with smaller up or down movements, the binomial valuation equation approaches the continuous-time valuation equation of Black-Scholes. PROS: CONS: Complicate to calibrate Expensive and time consuming to audit. Disclosure of the use of a binomial model prevents the use of Black-Scholes model in future. Being discrete, it does not produce exact answers. By hand, it would take a long time to price an option using a lot of time intervals. At least with the Cox-Ross-Rubinstein Model, it must use a constant volatility, a downside that the Black-Scholes PDE has as well. Assumptions can be examined easily Can use term structure of risk-free volatility and dividend yield. Can incorporate various different assumptions such as probabilities of exercise termination and retirement. It uses relatively simple Mathematics. It can be used to price American and Bermudan options. It can be implemented in computer programs. It can be adapted to various kinds of stock features (like dividends)