Suppose you were replicating a two-period put option in a binomial tree.Then,the replicating strategy involves an initial short position in the underlying stock that
A)is held unchanged to maturity.
B)is increased in size (i.e. ,becomes more short)after one period.
C)is increased in size (i.e. ,becomes more short)if the price goes down in the first period and decreased in size (becomes less short)if the price goes up in the first period.
D)is decreased in size (i.e. ,becomes less short)if the price goes down in the first period and increased in size (becomes more short)if the price goes up in the first period.

Question

Quizplus · Accepted Answer

In a binomial model for option pricing, the replicating strategy for a put option involves adjusting the position in the underlying stock based on the movement of the stock price. If the price goes down in the first period, the strategy involves increasing the size of the short position (becoming more short) to hedge against further decreases. Conversely, if the price goes up, the strategy involves decreasing the size of the short position (becoming less short) to adjust for the reduced likelihood of exercising the put option. This dynamic adjustment ensures that the replicating portfolio matches the payoff of the put option at maturity.

Suppose You Were Replicating a Two-Period Put Option in a Binomial