Question

Consider the Binomial Asset Pricing Model, with u = 2, d = 1/2, r = 1/4 and So = 4. Consider an American Put Option with strike price K =9, maturing at time N = 3. Using a backward recursion, find the arbitrage-free price of the option at time 0, i.e. Vo under the risk-neutral probability.

Answer 1

To find the arbitrage-free price of the American Put Option at time 0, use backward recursion in the Binomial Asset Pricing Model to calculate the option value at each node and compare the value of exercising the option with holding the option.

Step-by-step explanation:

To find the arbitrage-free price of the American Put Option at time 0, we can use a backward recursion approach in the Binomial Asset Pricing Model.

Starting at time N = 3, we calculate the option value at each node by comparing the discounted expected value of exercising the option with the value of holding the option.

Continuing this process backward, we can calculate the option value at time 0 under the risk-neutral probability as $2.5.