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2007 April Q3

D

Darragh Kelly

Ton up Member
Hi,

For Q3 part (i) the derivative only pays out if S2<S0. In the q we don't know d or u...are we assuming (as we did in part (iii)) that the assumption ud=1 holds? If this didn't hold could we not end up with a situation where there is a payout in the middle node ie another situation where S2<S0? Assume d=0.89 and u =1.055, and S0=100, then in the middle node S2 = 100*0.89*1.055 = 93.895<100, and the bottom node S2 = 100*0.89^2 = 79.21? If we assume ud=1 then as per the solution the derivative only pays out after 2 down moves?

Thanks,

Darragh
 
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