Consider a six month American put option on 500 ounces of gold with a strike of $1300 per ounce. The spot price per ounce of gold is $1300 and the annual financing rate is 2% on a continuously compounded basis. Finally, gold annual volatility is 20%. Assume no storage costs and a zero lease rate on gold. In answering the questions below use a binomial tree with two steps.
1. Compute u, d, as well as p for the standard binomial model.
2. Value the option at time 0 using the binomial tree.
3. How would you hedge a long position in the put option at time 0 with a portfolio composed of a position in gold, and a cash borrowing or lending position?