Markets

and Derivatives 2014/15

Problemset 4
The exercises in this problem set corresponds Chapters 3 of the course.
You do NOT have to hand in solutions to this problem set, but you are
expected to participate in solving these exercises during your seminar class
on November 11th.
1) A stock price is currently at 40$. It is known that at the end of one month
the price will be either $42 or $38. The risk free interest rate is 8% per
annum, continuously compounded. What is the value of a one-month
European Call option with strike price 39$?

Solution 1) Consider a portfolio of :
-1 call option
+ shares.

If the stock price rises to $42, this is worth 42-3. If the stock price falls
to $38, then it is worth 38. These are the same when:

42 -3=38 or = 0.75.

The value of that portfolio in one month is 28.5$ for both stock prices.
Its value today must be the present value of 28.5 or
28.5e(-0.08*1/12)=28.31. This means that: -f+40 =28.31, where f is the call
price. For delta=0.75, the call price is 40*0.75-28.31=$1.69

Alternatively, we can calculate the probability p of an up-move in a risk-
neutral world. This must satisfy:

42p+38(1-p)=40e(0.08*1/12)

so p=0.5669. The value of the option is the expected payoff discounted at
the risk free rate or: (3*0.5699+0*0.4331)e(0.08*1/12)=1.69

This is the same result as for the previous calculation.

2) A stock price is currently at $100. Over each of the next two six-month
periods it is expected to go up by 10% or down by 10%. The risk free rate
is 8% annually, continuously compounded. What is the value of a one-
year European call with a strike price of 100? What is the value of a
European put similar? Verify that put-call parity holds.

Solution 2)

u=1.10 and d=0.90. r=0.08 so,

=(e(0.08*0.5)-0.9)/(1.1-0.9)=0.7041

The tree for stock price movements looks like this, we work backwards to
determine the call option price:

121#
21#

110#
14.2063#
100#
9.6104#

99#
0#
90#
0#
81#
0#

Or directly by:
e(-2*0.08*0.5)(0.70412*21+2*0.7041*0.2959*0+0.29592*0)=9.61

Similar for the put:

110#
0.2843#
100#
1.9203#

121#
0#

99#
1#
90#
6.0781#
81#
19#

e(-2*0.08*0.5)(0.70412*0+2*0.7041*0.2959*1+0.29592*19)=1.9203

Put call parity: The value of the put + stock = 101.9203
The value of the call + present value of the strike =
= 9.61+100e(-0.08)=101.9203.
Put call parity holds!

3) You want to create a forward contract, which has the call from example 2)
as the underlying, what would be the correct forward price? Create a no-
arbitrage strategy to show that your forward price is correct.

Solution 3): we know that S=PV(F), so F=9.6104*e(0.08)=10.4108. The
underlying has no cost or yield.

Or, using a tree:

21'
10.5892'

9.6104'
0'

0'
+10.4108'

0'
+10.4108'

by definition, the forward has a current value equal to zero, so:
e(-2*0.08*0.5)(0.70412*(21-F)+2*0.7041*0.2959*(-F)+0.29592*(-F))=0
Solving for F gives: 0.70412*21+0.70412 (-F)+0.4167(-F)+ 0.29592*(-F)=0
So: 10.4108=F


Proof with no arbitrage strategy:





t=0

t=1






c=21
c=0

Forward (F=10.4108)
0

10.5892
-10.4108





0

10.5892
-10.4108


Long Call


-9.6104
+21
0
Borrow PV(10.4108)
+9.6104
-10.4108
-10.4108





0

10.5892
-10.4108

4) You want to price a European call with strike price of 15, which has the
put from example 2) as its underlying.

Solution 4) Using the tree we determine the payoffs:

The price of the call is:

e(-2*0.08*0.5)(0.70412*(0)+2*0.7041*0.2959*(0)+0.29592*(4))=
= e(-2*0.08*0.5)0.35023 = 0.3233

0'
0'

1.9203'
0.3233'

1'
0'

19'
4'


5) A stock price is currently at $25. It is known that at the end of two months
it will be either $23 or $27. The risk free interest rate is 10% per annum
with continuous compounding. Suppose ST is the stock price at the end of
two months. What is the value of a derivative that pays off max(ST2-K,0) at
this time, for K= 600? What is the that you need to create a risk-free
portfolio of the stock and this derivative? Use no-arbitrage pricing and
confirm your calculation with risk-neutral pricing.

Solution 5) At the end of two months, this derivative will have a payoff of
either 0 (if the stock price is 23) or 129 (if the stock price is 27). Consider
a portfolio consisting of:

+ shares
-1 derivative

The value of the portfolio is either 27-129 or 23 in two months. Lets
set:

27-129=23, so = 32.25.

The value of the portfolio is risk free and equal to 741.75. The current
value of this portfolio is *25-f.

Since the portfolio is risk free, it must earn the risk free rate:

(*25-f) e(0.1*2/12)=741.75

f = 76.76.

The value of the derivative is $76.76

This can also be confirmed by risk-neutral pricing: u=1.08, d=0.92, so

=(e(0.1*2/12)-0.92)/(1.08-0.92)=0.6050

f=e(-0.1*2/12)(0.6050*129+(1-0.6050)*0)=76.76

We can confirm the price using risk-neutral pricing.