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Price options and bonds via binomial no-arbitrage

Last updated: Mar 29, 2026

Quick Overview

This question evaluates competence in no-arbitrage pricing, risk-neutral valuation, early-exercise features of American versus European options, and short-rate tree bond valuation within the Statistics & Math domain.

  • medium
  • Citibank
  • Statistics & Math
  • Data Scientist

Price options and bonds via binomial no-arbitrage

Company: Citibank

Role: Data Scientist

Category: Statistics & Math

Difficulty: medium

Interview Round: Take-home Project

Use binomial no-arbitrage to price options and bonds. Part A (equity/options): Stock S0=100; two periods; per-period up factor u=1.25 and down factor d=0.8; risk-free rate per period r=5% (simple); strike K=100. 1) Compute the risk-neutral probability q and the European call price at t=0 by backward induction. 2) Price the American put and identify any node(s) where early exercise is optimal. 3) Prove whether early exercise of a non-dividend-paying American call can ever be optimal in this setup and explain. Part B (rates/bonds): A two-period short-rate tree with r0=5%; next period r_u=7%, r_d=3%; final period from r_u → {9%, 5%}, from r_d → {4%, 2%}. Assume risk-neutral q=0.5 at each node and discount factors (1+r_node)^{-1} per period. 4) Price a zero-coupon bond maturing at t=2 with face 100. 5) Price a two-period coupon bond with face 100 and coupon 5 paid at t=1 and t=2; report its yield to maturity and explain the rational (no-arbitrage) pricing principle you used.

Quick Answer: This question evaluates competence in no-arbitrage pricing, risk-neutral valuation, early-exercise features of American versus European options, and short-rate tree bond valuation within the Statistics & Math domain.

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Oct 13, 2025, 9:49 PM
Data Scientist
Take-home Project
Statistics & Math
6
0

Binomial No-Arbitrage Pricing: Options and Bonds

Setup and Assumptions

  • Two-period models; per-period simple compounding.
  • Discount per period: (1 + r_node)^{-1}.
  • No dividends on the equity in Part A.

Part A: Equity and Options (Two-Period Binomial Stock Tree)

  • Stock: S0 = 100
  • Per-period up factor u = 1.25; down factor d = 0.8
  • Risk-free rate per period r = 5% (simple), so 1 + r = 1.05
  • Strike K = 100

Tasks:

  1. Compute the risk-neutral probability q and the European call price C0 by backward induction.
  2. Price the American put P0 and identify any node(s) where early exercise is optimal.
  3. Prove whether early exercise of a non-dividend-paying American call can ever be optimal in this setup and explain.

Part B: Short-Rate Tree (Two Periods)

  • Short rates:
    • t=0: r0 = 5%
    • t=1: up node ru = 7%, down node rd = 3%
    • t=2: from ru → {9%, 5%}, from rd → {4%, 2%}
  • Risk-neutral probability at each node q = 0.5
  • Discount per period using the node’s short rate: (1 + r_node)^{-1}

Tasks: 4) Price a zero-coupon bond maturing at t=2 with face 100. 5) Price a two-period coupon bond with face 100 and coupon 5 paid at t=1 and t=2; report its yield to maturity (per period) and explain the no-arbitrage pricing principle used.

Solution

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