The up movement parameter U=1.20, and the down movement parameter D=0.833. We calculate the probability of an up move πU = (1 + 0.04 – 0.833)/(1.2 – 0.833) = 0.564. The call is out of the money in the event of a down movement, and has an intrinsic value of $20 in the event of an up movement. Therefore, the estimated value of the call is C = (0.564) × $20 / (1.04) = $10.85. Thus, the price of $11.11 is too high and the call is overpriced. |
