Today’s class problem solutions for parts A-D applying risk neutral valuation

Today, we discussed the risk neutral valuation approach to pricing options, and today’s class problem assignment was to work parts A through D of the  Option Pricing Class Problem, relying solely upon the risk neutral valuation approach.

As I pointed out during today’s class meeting, the replicating portfolio and delta hedging approaches both imply that a risk neutral valuation exists between an option (both the call and put varieties) and its underlying asset.  This is analytically shown in sections 5 and 6 (located on pp. 8-9) of my Binomial Option Pricing Model (single-period) teaching note which was assigned for October 23.  A particularly useful advantage of the risk neutral valuation approach (compared with the replicating portfolio and delta hedging approaches) is that it is computationally simpler and particularly well suited for modeling multi-timestep option pricing problems.

Here are the solutions for parts A through D (click on the image for a full-size PDF version that you can print out):

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