Value the option at time zero using the binomial tree

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Consider a six month American put option on 500 ounces of gold with a strike of $1300 per ounce. The spot price per ounce of gold is $1300 and the annual financing rate is 2% on a continuously compounded basis. Finally, gold annual volatility is 20%. Assume no storage costs and a zero lease rate on gold. In answering the questions below use a binomial tree with two steps.

1. Compute u, d, as well as p for the standard binomial model.

2. Value the option at time 0 using the binomial tree.

3. How would you hedge a long position in the put option at time 0 with a portfolio composed of a position in gold, and a cash borrowing or lending position?

Reference no: EM131346541

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