This question is one on a recombining binomial lattice. It gives us values for the parameters r, sigma (the vol), the share price at time0, and u, the size of an 'up-jump' along with its probability. What it does not give is d, the size of the 'down-jump'. This is essential for the calculations that follow. The solution in the examiner's report neatly assumes that d = 1/u and so, by design, the lattice may evolve back to its original state after two time periods. I have not found in any of the readings the requirement that d.u=1 Is this one of those questions where "the students were given credit for making appropriate assumptions?". If it is, the report makes no mention of that and leave one with the impression that this is a characteristic of the recombining binomial model.
You have posted in the exam discussions section. This has been answered in the subject section before: http://www.acted.co.uk/forums/showthread.php?t=749
Thanks CA2 student. They've used the binomial approximation to the cts-time logN model (although no proof is given as to why these values for d and u approximate the model, one of those "it can be shown that...")
