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SECTION B: ANSWER ANY THREE QUESTIONS QUESTION TWO Wila owns 500 shares of Deli stock, which is listed on LuSE. Today is April 14 th, 2024 and the stock, currently trading at K63, is already down since the time Wila purchased it. Fearing further declines, he decides to hedge with Deli put options with a strike of K60, and expiring in August 2024 (a 5-month maturity). As a financial intermediary, you are willing to write the options to Wila and need to price them. The options are American style. To this end, you look up the implied volatility from some traded options on Deli and observe that it is at

`35%`

per annum. You also check Deli stock and observe that the company will pay a dividend of

`K3`

in 2.5 months from today and a dividend of

`K5`

in 6.5 months from today. The Bank of Zambia has recently cut the risk-free- rate of interest to

`0.10%`

p.a. (Continuously compounded) REQUIRED: A. Use a two-step binomial tree to calculate the option price. [10 Marks] B. An analyst working for the intermediary questions your choice of the pricing model and claims that you should have used the Black Scholes Model. How would you defend the choice of using the binomial model? [5 Marks] C. A stock price is currently K50. It is known that at the end of six months, it will be either K60 or K42. The risk-free rate of interest with continuous compounding is

`12%`

per annum. Using no-arbitrage arguments (NOT risk-neutral valuation), calculate the value of a six-month European call option on the stock with an exercise price of

`K48`

. [10 Marks] [TOTAL: 25 MARKS] Page 3 of 8