Trading Case OP1

Case Objective

To understand the one-period binomial option pricing model.

Key Concepts

Binomial option pricing model; option replication.

Case description

In OP1 four markets are open: stock, bond, put and call option markets. The markets cover one month of calendar time, but you trade only the first day. That is, at the close of the first trading day time will flash by and your position is marked to the realized end of month payoffs. You can trade the stock at 20 during the trading day. By the end of the month the stock is equally likely to go up to 40 or down to 10 which in turn determines the realized end of month option values. The interest rate for borrowing and lending is 1% for the month. Any positive cash balance you have at the end of the first trading day earns 1% interest and any negative balance pays 1%. Both options expire at the end of the month, and have a strike price of 25. There is price discovery in each market except the stock, which you can buy or sell at 20 during the trading period.

Case Data

The following one-period binomial tree shows the cash flows from each security at the end of the month depending on whether the stock goes up or down which is equally likely:

Earning Grade Cash

In the trading period securities are exchanged using market cash. Your end of period final market cash balance determines your earning grade cash as follows: