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CHAPTER 4: OPTION PRICING MODELS: THE BINOMIAL MODEL END-OF-CHAPTER QUESTIONS AND PROBLEMS 1. When we price an option according to its boundary conditions, we do not find an exact price for the option. We provide only limits on the maximum and minimum price of an option or group of options. In the case of options differing by exercise prices or in the case of put-call parity, we can price only the relationship or difference between the option prices. We cannot price each option individually without an option pricing model; however, an option pricing model must provide prices that conform to the boundary conditions. Because boundary condition rules require fewer assumptions, we can say that they are more generally applicable and are more likely to hold in practice. They are incomplete, however, in the sense that they do not tell us exactly what the option price should be, which is what an option pricing model does tell us. 2. A binomial option pricing model enables us to see the relationship between the stock price and the call price. The model shows, in a simple framework, how to construct a riskless portfolio by appropriately weighting the stock against the option. By noting that the riskless portfolio should return the risk-free rate, we can see what the call price must be. We can also understand the forces that bring the call option price in line if it is not priced according to the model. In addition, the model illustrates the importance of revising the hedge ratio. Finally, the model is probably the best way to handle the problem of pricing an American option. 3. For a call, a hedge portfolio will consist of n shares of stock and one short call. The shares of stock, n, will be a long position that will reflect the next two possible values of the call and stock. The call is short because the call and stock move opposite each other, so a short position in the call is needed to offset a long position in the stock. If the option is a put, a long positio