A stock is currently selling for $50. The stock price could go up by 10% or fall by 5% each month. The monthly interest rate is 1% (periodic rate). Calculate the price of a European call option on the stock with an exercise price of $50 and a maturity of two months. (use the two-stage binomial method)
A) $5.10
B) $2.71
C) $4.78
D) $3.62

Question

Quizplus · Accepted Answer

The two-stage binomial method involves calculating the possible stock prices at maturity, determining the option payoff at those prices, and discounting back to the present value. The stock can go to $60.50 or $47.50 in the first month, and then to $66.55, $57.48, $49.88, or $45.13 in the second month. The call option payoffs are $16.55, $7.48, $0, and $0, respectively. Using risk-neutral probabilities and discounting at 1% per month, the present value of the option is approximately $2.71.

A Stock Is Currently Selling for $50