Changing the initial stock price affects the entire structure of the binomial tree and consequently the option's intrinsic value at each node. With a higher initial stock price (e.g., £110), the put option is less likely to be in the money at expiration, reducing its value. With a lower stock price (e.g., £90), the put becomes deeper in-the-money, increasing its intrinsic value and hence its price. Calculating these within the binomial tree shows significant variations in payoffs as initial stock price moves inversely with option value, aligning with the hypothesis that put option prices are inversely related to stock prices .

First, create a binomial tree model to establish the possible stock prices at each period. In two years, the stock price can move up to £60 (£50 * 1.2) or down to £40 (£50 * 0.8). For a two-year option, calculate all paths: (i) £72 (£60 * 1.2), (ii) £48 (£60 * 0.8 = £40 * 1.2), and (iii) £32 (£40 * 0.8). Calculate the option payoff for each terminal node (e.g., C=max(0, S-K) where K=£45), and discount these using the annual interest rate of 10% to the present value. The time value of money reflects how future cash flows, such as option payoffs, are worth less today, thus necessitating discounting using the risk-free rate .

The optimal exercise policy for an American put involves comparing the immediate exercise payoff at each node to the expected value of keeping the option. Calculate each node's exercise value (S-K) and the expected continuation value (future payoffs discounted to present). The strategy maximizes value by choosing the maximum between these two at every point in the tree, accounting for both current market conditions and potential future states. This dynamic strategy ensures the realization of maximum possible return based on prevailing market circumstances at all stages .

A replicating portfolio strategy aims to mimic the payoff of a put option by strategically investing in the underlying stock and a risk-free bond. For a European put, calculate the delta and B, representing the proportion of a stock and the bond necessary to create this portfolio. For each node in the binomial model, solve the two equations simultaneously based on the stock price changes to determine delta and bond positions. This portfolio should replicate the put option's payoff, ensuring that the option's value is equivalent to a synthetic hedge outcome .

In a binomial model, adjusting up (u) and down (d) movements affects price paths and option valuation. A larger 'u' implies a probability of higher end prices, likely reducing the put option's value due to fewer scenarios of being in-the-money. Conversely, a larger 'd' increases downward path probability, potentially increasing the put's value as it becomes more likely to be profitable at lower terminal prices. Adjusting these parameters alters risk assessments and expected payoffs within the model, demonstrating the sensitivity of option values to assumptions about price volatility and direction .

In the binomial model, adjusting the down movement factor (d) alters the likelihood of stock prices falling, impacting the probabilities of ending states and therefore the option's intrinsic value. A lowered 'd' increases the likelihood of reaching lower terminal nodes, enhancing the put option's due value as it suggests more favorable outcomes for in-the-money conditions. This alteration requires revaluation of end-state prices and pathways to ensure accurate option pricing, reflecting conditions where market downtrends in price adjustments become more favorable for the option's intrinsic profitability .

An adjustment to the risk-free interest rate changes the discount factor applied to future option payoffs. An increase in this rate decreases the present value of future payoffs, thus reducing the put option's price as expected returns are valued less today. Conversely, a decrease in the interest rate increases the value of these payoffs, raising the option's price. This sensitivity highlights how interest rate changes affect option valuation by altering the worth of future cash flows relative to today’s values in the option pricing model .

A change in the exercise price directly affects the intrinsic payoff at each node of the binomial tree. Higher exercise prices make it more likely that the option will be out-of-the-money, decreasing its value. Conversely, a lower strike price increases the option value as it enhances the likelihood of in-the-money scenarios at maturity. This requires recalculating option payoffs at each node for new exercise prices and discounting these values to ensure the accurate assessment of how sensitivity to exercise prices affects option valuation .

Increasing the 'up' movement factor (u) implies higher potential stock prices, leading to fewer end nodes with negative payoffs for the put option, thus reducing its total value. This means fewer paths reaching in-the-money scenarios for the put. Consequently, option strategies must adapt as higher 'u' settings signal bullish conditions that make put options less viable without adversarial risk hedging. This adjustment emphasizes the need to align option positions with projected market conditions that reflect these altered movements in stock price trajectories .

Put-call parity is a principle that defines the relationship between the prices of European call and put options with the same strike price and expiration. It states that Call Price + Present Value of Strike Price = Put Price + Stock Price. To verify this across a binomial model, calculate expected payouts for both the call and put options at terminal nodes, then discount each to present value. Compare combinations at every node throughout the tree to ensure this equality holds, tracking same parameters for both options as they evolve over time .