Problem Set 7 Q&A between a Finance 4366 student and Professor Garven…

Q (from a Finance 4366 student): “Hi Dr. Garven, I had a question on problem set 7 if you get the chance. Specifically, for problem number, 2 I’m confused how to do the "trial and error approach."

A (from Professor Garven): There are two ways to do trial and error – either manually, or via Solver. Start by using the Pricing of American Options on Non-Dividend Paying Stocks spreadsheet (listed under item 12’s third bullet point) on the course website lecture notes page, and replace the stock price (S), u, d, and interest rate (r) parameters on the “2 timestep put” worksheet tab with the S, u, d, and r parameters indicated in Problem 1 of Problem set 7. By doing this, you’ll obtain the answers for Problem 1A and 1B. Since the value of exercising the American put at the inception of the binomial tree is only K S(t) = $75 – $70 = $5, whereas the value of the American put is more than $5, the exercise price must be at least a penny higher than the current (date t) value of the American put option in order for it to be optimal to exercise the option immediately.

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