Question

Suppose the risk free rate today is 5% and in the next year the Federal Reserve will either lower the rate to 4% or raise it to 6%. In the risk- neutral world assume each is likely to happen. Compute the price of a European put option on the 2-year bond with face value $100, where the option expires in 1 year and the option's strike price is $90. Recall this means the bond matures 2 years after the option's expiration date and pays the bond holder $100 at the bond's maturity.

Answer 1

Solution:

we will be using our BA-II plus calculators to calculate the bond price in different scenarios.

Solution : We will be using our BA MD2 DEDN using plus our BA-7 calculator to the calculate boud price in different scenarios. We have with us: N= 2 (2 year Bond) 114=5% = 100 PMT=0 PV=? - Ou inputting the above values in TVM row of our calculator we get the price of the bond as: 90.70 - If 84% pra 92.45 If 8-6% PV2 88.999~ 89 U -12 = 812 90.70 Bond price = 89 dal 1.2 Payoff = 96-89 =1. to Strike for put = 90 8=4% BP = 92.45 Pay of were o (OTM put) Being a risk nental world taalu - is P = (1487-d) - 14.05 .812 (u-d) 1. 2 812 238 -288 .613 w Value of put - option & Expected Pay all (to) The value of the put = .613x1 to Option 2.5841 = .613 =5841. 14.05) 1.05 - 20