Critically discuss how the binomial model can be linked to the Black-Scholes-Merton option pricing formula.

Finance exam question 3

1a.Using the following information, calculate the price of a 12-month long put option using a two-step binomial tree procedure. S0= £20, K = £21, r = 5% (annual), σ = 40%.

You have the following equations:𝑝=𝑎−𝑑𝑢−𝑑(1)𝑎=𝑒𝑟∆𝑡(2)𝑢=𝑒𝜎√∆𝑡(3)𝑑=1𝑢(4)𝑓=[𝑝𝑓𝑢+(1−𝑝)𝑓𝑑]𝑒−𝑟∆𝑡(5)

b.Critically discuss how the binomial model can be linked to the Black-Scholes-Merton option pricing formula.

c.Critically discuss the concept of Option Delta.