**Trading Case
****OP2**** **

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**Case
Objective**

To
understand the two-period binomial option pricing model.

**Key
Concepts
**

Binomial
option pricing model; option replication; dynamic trading strategies.

**Case
description
**

There
is one stock, one bond, a put option and a call option.
Both options are American style options. Each trial of the trading case
covers two months of calendar time. The
FTS markets are open for the first trading day of each month and during this day
each American option can be exercised if desired. To exercise you need to put in the quantity and then click on
the button Exercise (see Generic Trading Screen below). Actual exercise is
executed at the end of the current trading period and the number to be exercised
is indicated with an additional /num in relevant position cell.

That
is, at the end of the first trading day time “flashes by” and then end of
month one realizations occur. Shortly
after, the first trading day of the second month opens.
The stock price at the beginning of the first month is 20, and at the end
of the month, it either goes up to 40 or down to 10. You can trade at this realized stock price (i.e.,
either 10 or 40) during
the first day of month two. At the
end of the second month, the stock value again either doubles or is halved
(i.e., three possibilities 5, 20, or 80 see below).
At the end of each trading day the interest rate is 1% for the remaining
month. That is, any surplus
(shortfall) of cash earns (pays) 1% per month.
Both options expire at the end of month two, and have a strike price
equal to 25.

In
summary, the price of the stock is fixed at 20 at the beginning of month 1, and
then at either 40 or 10 at the beginning of month 2, depending on whether an
uptick or downtick was realized. An
up or down tick is equally likely. All
other prices are determined by the traders as a result of their limit and market
orders.

**Case
Data**

The
following binomial tree shows the cash flows from each security at the end of
period 2. There are no cash
flows in period 1.

The
objective is to accumulate as much *grade
cash* per *trial* (two trading
periods) as possible. Your realized
final market cash position determines your grade cash as follows:

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:

© OS Financial Trading System 2001