1. Consider 3-step binomial model with one asset with initial price S(0) = 100. (a) For D=0.9, U – 1.1 and p= }: =
(i) Determine the distribution of the price S(t) for t = 1, 2, 3.
(ii) Compute the expected price E(S(t)) for t =1,2,3.
(iii) Determine the distribution of the return K(t) for t=1,2,3. (4) (iv) Compute the expected return E(K(t)) for t = 1,2,3. (4) (b) Suppose D = 0.9 and p = . Determine all values of U > D for which the expected return is:
(i) equal to 100:
(ii) smaller than 100;
(iii) bigger than 100.
(c) Let 0 <>
2. Let S and S, be two risky assets each following a 2-step binomial model with uniform probability and parameters Di = 10/11, U1 = 1.1 and D, 0.95, U2 = 1.05, respectively. In which asset it is more reasonable to invest? Explain your choice. The solution of this problem should contain a statement saying which of the two assets is better supported by an argument containing suitable computations. The solution may not be unique.
