Solution to Derivatives Markets: 3rd edition

SOA Exam MFE and CAS Exam 3 FE

Yufeng Guo
May 31, 2015

Contents
9.1 .
9.2 .
9.3 .
9.4 .
9.5 .
9.6 .
9.7 .
9.8 .
9.9 .
9.10
9.11
9.12
9.13
9.14
9.15
9.16
9.17
9.18
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10
10.11
10.12
10.13
10.14
10.15
10.16
10.17

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1
1
1
2
2
4
4
6
7
8
10
12
15
15
16
17
18
21
22
23
24
25
26
26
28
35
36
41
42
45
49
54
56
60
63

CONTENTS
10.18 . . . . . . . . . . . . . . . . .
10.19 . . . . . . . . . . . . . . . . .
10.20 . . . . . . . . . . . . . . . . .
10.21 . . . . . . . . . . . . . . . . .
10.22 . . . . . . . . . . . . . . . . .
10.23 . . . . . . . . . . . . . . . . .
11.1 . . . . . . . . . . . . . . . . .
11.2 . . . . . . . . . . . . . . . . .
11.3 . . . . . . . . . . . . . . . . .
11.4 . . . . . . . . . . . . . . . . .
11.5 . . . . . . . . . . . . . . . . .
11.6 . . . . . . . . . . . . . . . . .
11.7 . . . . . . . . . . . . . . . . .
11.8 . . . . . . . . . . . . . . . . .
11.9 . . . . . . . . . . . . . . . . .
11.10 . . . . . . . . . . . . . . . . .
11.11 . . . . . . . . . . . . . . . . .
11.12 . . . . . . . . . . . . . . . . .
11.13 . . . . . . . . . . . . . . . . .
11.14 . . . . . . . . . . . . . . . . .
11.15 . . . . . . . . . . . . . . . . .
11.16 . . . . . . . . . . . . . . . . .
11.17 . . . . . . . . . . . . . . . . .
11.18 . . . . . . . . . . . . . . . . .
12.1 skip this spreadsheet problem
12.2 skip this spreadsheet problem
12.3 . . . . . . . . . . . . . . . . .
12.4 . . . . . . . . . . . . . . . . .
12.5 . . . . . . . . . . . . . . . . .
12.6 . . . . . . . . . . . . . . . . .
12.7 . . . . . . . . . . . . . . . . .
12.8 . . . . . . . . . . . . . . . . .
12.9 . . . . . . . . . . . . . . . . .
12.10 . . . . . . . . . . . . . . . . .
12.11 . . . . . . . . . . . . . . . . .
12.12 Skip . . . . . . . . . . . . . .
12.13 . . . . . . . . . . . . . . . . .
12.14 . . . . . . . . . . . . . . . . .
12.15 . . . . . . . . . . . . . . . . .
12.16 . . . . . . . . . . . . . . . . .
12.17 . . . . . . . . . . . . . . . . .
12.18 . . . . . . . . . . . . . . . . .
12.19 . . . . . . . . . . . . . . . . .
12.20 . . . . . . . . . . . . . . . . .
12.21 . . . . . . . . . . . . . . . . .
13.1 . . . . . . . . . . . . . . . . .
deeperunderstandingfastercalc.com

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65
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120
ii

CONTENTS
13.2 . . . . . . .
13.3 . . . . . . .
13.4 . . . . . . .
13.5 . . . . . . .
13.6 . . . . . . .
13.7 . . . . . . .
13.8 . . . . . . .
13.9 . . . . . . .
13.10 . . . . . . .
13.11 . . . . . . .
13.12 . . . . . . .
13.13 . . . . . . .
13.14 . . . . . . .
13.15 . . . . . . .
13.16 . . . . . . .
13.17 . . . . . . .
13.18 . . . . . . .
13.19-13.20 Skip
14.1 . . . . . . .
14.2 . . . . . . .
14.3 . . . . . . .
14.4 . . . . . . .
14.5 . . . . . . .
14.6 . . . . . . .
14.7 . . . . . . .
14.8 . . . . . . .
14.9 . . . . . . .
14.10 . . . . . . .
14.11 . . . . . . .
14.12 . . . . . . .
14.13 . . . . . . .
14.14 . . . . . . .
14.15 Skip . . . .
14.16 . . . . . . .
14.17 . . . . . . .
14.18 . . . . . . .
14.19 . . . . . . .
14.20 . . . . . . .
14.21 . . . . . . .
14.22 . . . . . . .
18.1 . . . . . . .
18.2 . . . . . . .
18.3 . . . . . . .
18.4 . . . . . . .
18.5 . . . . . . .
18.6 . . . . . . .

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iii

CONTENTS
18.7 . . . . . .
18.8 . . . . . .
18.9 . . . . . .
18.10 . . . . . .
18.11 . . . . . .
18.12 . . . . . .
18.13 . . . . . .
18.14 . . . . . .
18.15 . . . . . .
19.1 . . . . . .
19.2 . . . . . .
19.3 . . . . . .
19.4 . . . . . .
19.5 . . . . . .
19.6 . . . . . .
19.7-19.17 Skip
20.1 . . . . . .
20.2 . . . . . .
20.3 . . . . . .
20.4 . . . . . .
20.5 . . . . . .
20.6 . . . . . .
20.7 . . . . . .
20.8-20.14 Skip
21.1 . . . . . .
21.2 . . . . . .
21.3 . . . . . .
21.4 . . . . . .
21.5 . . . . . .
21.6 . . . . . .
21.7 . . . . . .
21.8 . . . . . .
21.9 . . . . . .
21.10 . . . . . .
21.11 . . . . . .
21.12 . . . . . .
21.13 . . . . . .
21.14 . . . . . .
23.1 . . . . . .
23.2 . . . . . .
23.3-23.17 Skip
24.1 . . . . . .
24.2 . . . . . .
24.3-24.5 Skip .
24.6 . . . . . .
24.7 . . . . . .

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160
161
163
164
165
169
171
172
172
173
174
175
176
178
179
181
181
183
183
184
184
185
185
186
186
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187
188
190
192
192
193
193
194
195
196
196
197
198
198
198
200
200
200
200
iv

CONTENTS
24.8 . . . . . . . . . . . . . . .
24.9-24.20 Skip . . . . . . . . .
25.1 . . . . . . . . . . . . . . .
25.2 . . . . . . . . . . . . . . .
25.3 . . . . . . . . . . . . . . .
25.4 . . . . . . . . . . . . . . .
25.5 . . . . . . . . . . . . . . .
25.6 . . . . . . . . . . . . . . .
25.7 . . . . . . . . . . . . . . .
25.8 . . . . . . . . . . . . . . .
25.9 . . . . . . . . . . . . . . .
25.10 . . . . . . . . . . . . . . .
25.11 . . . . . . . . . . . . . . .
25.12 . . . . . . . . . . . . . . .
25.13 . . . . . . . . . . . . . . .
25.14 Skip . . . . . . . . . . . .
25.18 . . . . . . . . . . . . . . .
25.19-25.20 Skip . . . . . . . .
Recommendations on using this

CONTENTS
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solution

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manual:

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201
201
201
203
205
206
208
210
217
219
219
219
221
222
224
225
225
227

1. Obviously, youll need to buy Derivatives Markets (3rd edition) to see the
problems.
2. Make sure you download the textbook errata from http://derivatives.
kellogg.northwestern.edu/typos3e.html

deeperunderstandingfastercalc.com

9.1

CONTENTS

9.1
S0 = 32
T = 6=12 = 0:5
C = 2:27
r = 0:04

K = 35
= 0:06

C + P V (K) = P + S0 e T
2:27 + 35e 0:04(0:5) = P + 32e

0:06(0:5)

P = 5: 522 7

9.2
S0 = 32
T = 6=12 = 0:5
K = 30
C = 4:29
P = 2:64
r = 0:04
C + P V (K) = P + S0 P V (Div)
4:29 + 30e 0:04(0:5) = 2:64 + 32 P V (Div)
P V (Div) = 0:944

9.3
S0 = 800
r = 0:05
=0
T =1
K = 815
C = 75
P = 45
a. Buy stock+ sell call+buy put=buy P V (K)
C + P V (K) = P + S0
! P V (K = 815) = S0 +
C + |{z}
P = 800 + ( 75) + 45 = 770
|{z}
|{z}
buy sto ck

sell call

buy put

So the position is equivalent to depositing 770 in a savings account (or buying a bond with present value equal to 770) and receiving 815 one year later.
770eR = 815
R = 0:056 8
So we earn 5:68%.
b. Buying a stock, selling a call, and buying a put is the same as depositing
P V (K) in the savings account. As a result, we should just earn the risk free
interest rate r = 0:05. However, we actually earn R = 0:056 8 > r. To arbitrage,
we "borrow low and earn high." We borrow 770 from a bank at 0.05%. We use
the borrowed 770 to nance buying a stock, selling a call, and buying a put.
Notice that the net cost of buying a stock, selling a call, and buying a put is
770.
One year later, we receive 770eR = 815. We pay the bank 770e0:05 = 809:
48. Our prot is 815 809: 48 = 5: 52 per transaction.
If we do n such transactions, well earn 5: 52n prot.

Alternative answer: we can burrow at 5% (continuously compounding) and

lend at 5:6 8% (continuously compounding), earning a risk free 0.68%. So if
we borrow $1 at time zero, our risk free prot at time one is e0:0568 e0:05 =
0:00717 3; if we borrow $770 at time zero, our risk free prot at time one is
deeperunderstandingfastercalc.com

9.4

CONTENTS

0:00717 3 770 = 5: 52. If we borrow n dollars at time zero, well earn 0:00717 3n
dollars at time one.
c. To avoid arbitrage, we need to have:
P V (K = 815) = S0 +
C + |{z}
P = 815e 0:05 = 775: 25
|{z}
|{z}
buy stock

!C

P = S0

d. C P = S0
If K = 780
If K = 800
If K = 820
If K = 840

sell call

P V (K) = 800

buy put

775: 25 = 24: 75

P V (K) = 800 Ke rT = 800 Ke

C P = 800 780e 0:05 = 58: 041
C P = 800 800e 0:05 = 39: 016
C P = 800 820e 0:05 = 19: 992
C P = 800 840e 0:05 = 0:967

0:05

9.4
To solve this type of problems, just use the standard put-call parity.
To avoid calculation errors, clearly identify the underlying asset.
The underlying asset is e1. We want to nd the dollar cost of a put option
on this underlying.
The typical put-call parity:
C + P V (K) = P + S0 e T
C, K, P , and S0 should all be expressed in dollars. S0 is the current (dollar
price) of the underlying. So S0 = $0:95.
C = $0:0571
K = $0:93
is the internal growth rate of the underlying asset (i.e. e1). Hence = 0:04
Since K is expressed in dollars, P V (K) needs to be calculated using the
dollar risk free interest r = 0:06.
0:0571 + 0:93e 0:06(1) = P + 0:95e 0:04(1)
P = $0:02 02

9.5
As I explained in my study guide, dont bother memorizing the following complex formula:
1 1
; ;T
C$ (x0 ; K; T ) = x0 KPf
x0 K
Just use my approach to solve this type of problems.
Convert information to symbols:

deeperunderstandingfastercalc.com

9.5

CONTENTS

The exchange rate is 95 yen per euro. Y 95 =e1 or Y 1 =e

1
95

Yen-denominated put on 1 euro with strike price Y100 has a premium Y8:763
! (e1 ! Y 100)0 =Y8:763
Whats the strike price of a euro-denominated call on 1 yen? eK ! 1Y
Calculate the price of a euro-denominated call on 1 yen with strike price eK
(eK ! 1Y )0 = e?
1
!Y1
100
1
=e0:01
The strike price of the corresponding euro-denominated yen call is K =e
100
1
1
1
e
!Y1 =
(e1 ! Y 100)0 =
(Y 8:763)
100
100
100
0

e1 ! Y 100

1
, we have:
95
1
1
1
(Y 8:763) =
(8:763) e
=e9: 224 2
100
100
95
1
! e
! Y 1 =e9: 224 2 10 4
100
0
Since Y 1 =e

10

So the price of a euro-denominated call on 1 yen with strike price K =e

is e9: 224 2

10

deeperunderstandingfastercalc.com

1
100

9.6

CONTENTS

9.6
The underlying asset is e1. The standard put-call parity is:
C + P V (K) = P + S0 e T
C, K, P , and S0 should all be expressed in dollars. S0 is the current (dollar
price) of the underlying.
is the internal growth rate of the underlying asset (i.e. e1).
Well solve Part b rst.
b. 0:0404 + 0:9e 0:05(0:5) = 0:0141 + S0 e 0:035(0:5)
S0 = $0:920 04
So the current price of the underlying (i.e. e1) is S0 = $0:920 04. In other
words, the currency exchange rate is $0:920 04 =e1
a. According to the textbook Equation 5.7, the forward price is:
F0;T = S0 e T erT = 0:920 04e 0:035(0:5) e0:05(0:5) = $0:926 97

9.7
The underlying asset is one yen.
a. C + Ke rT = P + S0 e T
0:0006 + 0:009e 0:05(1) = P + 0:009e 0:01(1)
0:0006 + 0:008561 = P + 0:008 91
P = $0:00025

b. There are two puts out there. One is the synthetically created put using
the formula:
P = C + Ke rT S0 e T
The other is the put in the market selling for the price for $0:0004.
To arbitrage, build a put a low cost and sell it at a high price. At t = 0, we:
Sell the expensive put for $0:0004
Build a cheap put for $0:00025. To build a put, we buy a call, deposit
Ke rT in a savings account, and sell e T unit of Yen.

Sell expensive put

Buy call
Deposit Ke rT in savings
Short sell e T unit of Yen
Total
0:0004

0:0006

0:009e

t=0
0:0004
0:0006
0:009e 0:05(1)
0:009e 0:01(1)
$0:00015

0:05(1)

deeperunderstandingfastercalc.com

+ 0:009e

0:01(1)

T =1
ST < 0:009
ST 0:009
0
0:009
ST
0

T =1
ST 0:009
0
ST 0:009
0:009
ST
0

= $0:00015
4

9.7

CONTENTS

At t = 0, we receive $0:00015 yet we dont incur any liabilities at T = 1 (so

we receive $0:00015 free money at t = 0).
c. At-the-money means K = S0 (i.e. the strike price is equal to the current
exchange rate).
Dollar-denominated at-the-money yen call sells for $0.0006. To translate this
into symbols, notice that under the call option, the call holder can give $0:009
and get Y 1.
"Give $0:009 and get Y 1" is represented by ($0:009 ! Y 1). This options
premium at time zero is $0.0006. Hence we have:
($0:009 ! Y 1)0 = $0:0006
We are asked to nd the yen denominated at the money call for $1. Here
the call holder can give c yen and get $1. "Give c yen and get $1" is represented
by (Y c ! $1). This options premium at time zero is (Y c ! $1)0 .
First, we need to calculate c, the strike price of the yen denominated dollar
1
. So the at-thecall. Since at time zero $0:009 = Y 1, we have $1 = Y
0:009
1
money yen denominated call on $1 is c =
. Our task is to nd this options
0:009
1
! $1 =?
premium: Y
0:009
0
Well nd the premium for Y 1 !$0:009, the option of "give 1 yen and get
$0:009." Once we nd this premium, well scale it and nd the premium of "give
1
yen and get $1."
0:009
Well use the general put-call parity:
(AT ! BT )0 + P V (AT ) = (BT ! AT )0 + P V (BT )
($0:009 ! Y 1)0 + P V ($0:009) = (Y 1 ! $0:009)0 + P V (Y 1)
P V ($0:009) = $0:009e 0:05(1)
Since we are discounting $0.009 at T = 1 to time zero, we use the dollar
interest rate 5%.
P V (Y 1) = $0:009e 0:01(1)
If we discount Y1 from T = 1 to time zero, we get e
equal to $0:009e 0:01(1) .
So we have:
$0:0006+$0:009e

0:05

= (Y 1 ! $0:009)0 + $0:009e

0:01(1)

yen, which is

0:01(1)

(Y 1 ! $0:009)0 = $2: 506 16 10 4

1
1
2: 506 16 10
Y 1 ! $1
=
(Y 1 ! $0:009)0 = $
0:009
0:009
0:009
0
2
2:
784
62
10
784 62 10 2 = Y
= Y 3: 094
0:009
deeperunderstandingfastercalc.com

= $2:

9.8

CONTENTS

So the yen denominated at the money call for $1 is worth $2: 784 62
or Y 3: 094.

10

We are also asked to identify the relationship between the yen denominated
at the money call for $1 and the dollar-denominated yen put. The relationship
is that we use the premium of the latter option to calculate the premium of the
former option.
Next, we calculate the premium for the yen denominated at-the-money put
for $1:
$!Y

1
0:009

=
0

1
($0:009 ! Y 1)0
0:009

1
$0:0006 = $ 0:0 666 7
=
0:009
1
= Y 0:0 666 7
= Y 7: 407 8
0:009
So the yen denominated at-the-money put for $1 is worth $ 0:0 666 7 or Y
7: 407 8.
I recommend that you use my solution approach, which is less prone to errors
than using complex notations and formulas in the textbook.

9.8
The textbook Equations 9.13 and 9.14 are violated.
This is how to arbitrage on the calls. We have two otherwise identical
calls, one with $50 strike price and the other $55. The $50 strike call is more
valuable than the $55 strike call, but the former is selling less than the latter.
To arbitrage, buy low and sell high.
We use T to represent the common exercise date. This denition works
whether the two options are American or European. If the two options are
American, well nd arbitrage opportunities if two American options are exercised simultaneously. If the two options are European, T is the common
expiration date.
The payo is:
Transaction
Buy 50 strike call
Sell 55 strike call
Total

t=0
9
10
1

T
ST < 50
0
0
0

T
50
ST
0
ST

ST < 55
50
50

T
ST 55
ST 50
(ST 55)
5

At t = 0, we receive $1 free money.

At T , we get non negative cash ows (so we may get some free money, but
we certainly dont owe anybody anything at T ). This is clearly an arbitrage.

deeperunderstandingfastercalc.com

9.9

CONTENTS

This is how to arbitrage on the two puts. We have two otherwise identical
puts, one with $50 strike price and the other $55. The $55 strike put is more
valuable than the $50 strike put, but the former is selling less than the latter.
To arbitrage, buy low and sell high.
The payo is:
T
T
T
Transaction
t = 0 ST < 50
50 ST < 55 ST 55
Buy 55 strike put
6
55 ST
55 ST
0
Sell 50 strike put 7
(50 ST ) 0
0
Total
1
5
55 ST > 0
0
At t = 0, we receive $1 free money.
At T , we get non negative cash ows (so we may get some free money, but
we certainly dont owe anybody anything at T ). This is clearly an arbitrage.

9.9
The textbook Equation 9.15 and 9.16 are violated.
We use T to represent the common exercise date. This denition works
whether the two options are American or European. If the two options are
American, well nd arbitrage opportunities if two American options are exercised simultaneously at T . If the two options are European, T is the common
expiration date.
This is how to arbitrage on the calls. We have two otherwise identical calls,
one with $50 strike price and the other $55. The premium dierence between
these two options should not exceed the strike dierence 15 10 = 5. In other
words, the 50-strike call should sell no more than 10 + 5. However, the 50-strike
call is currently selling for 16 in the market. To arbitrage, buy low (the 55-strike
call) and sell high (the 50-strike call).
The $50 strike call is more valuable than the $55 strike call, but the former
is selling less than the latter.
The payo is:
T
T
T
Transaction
t = 0 ST < 50 50 ST < 55
ST 55
Buy 55 strike call
10
0
0
ST 55
Sell 50 strike call 16
0
(ST 50)
(ST 50)
Total
6
0
(ST 50)
5
5
So we receive $6 at t = 0. Then at T , our maximum liability is $5. So make
at least $1 free money.
This is how to arbitrage on the puts. We have two otherwise identical puts,
one with $50 strike price and the other $55. The premium dierence between
these two options should not exceed the strike dierence 15 10 = 5. In other
deeperunderstandingfastercalc.com

9.10

CONTENTS

words, the 55-strike put should sell no more than 7 + 5 = 12. However, the
55-strike put is currently selling for 14 in the market. To arbitrage, buy low
(the 50-strike put) and sell high (the 55-strike put).
The payo is:
T
T
T
Transaction
t = 0 ST < 50
50 ST < 55
ST 55
Buy 50 strike put
7
50 ST
0
0
Sell 55 strike put 14
(55 ST )
(55 ST )
0
Total
7
5
(55 ST ) < 5 0
So we receive $7 at t = 0. Then at T , our maximum liability is $5. So make
at least $2 free money.

9.10
Suppose there are 3 options otherwise identical but with dierent strike price
K1 < K2 < K3 where K2 = K1 + (1
) K3 and 0 < < 1.
Then the price of the middle strike price K2 must not exceed the price of a
diversied portfolio consisting of units of K1 -strike option and (1
) units
of K3 -strike option:
C [ K1 + (1
P [ K1 + (1

) K3 ]
) K3 ]

C (K1 ) + (1
P (K1 ) + (1

) C (K3 )
) P (K3 )

The above conditions are called the convexity of the option price with respect
to the strike price. They are equivalent to the textbook Equation 9.17 and 9.18.
If the above conditions are violated, arbitrage opportunities exist.
We are given the following 3 calls:
Strike
K1 = 50 K2 = 55
Call premium 18
14
50 + (1
! = 0:5

K3 = 60
9:50

) 60 = 55
0:5 (50) + 0:5 (60) = 55

Lets check:
C [0:5 (50) + 0:5 (60)] = C (55) = 14
0:5C (50) + 0:5C (60) = 0:5 (18) + 0:5 (9:50) = 13: 75
C [0:5 (50) + 0:5 (60)] > 0:5C (50) + 0:5C (60)
So arbitrage opportunities exist. To arbitrage, we buy low and sell high.
The cheap asset is the diversied portfolio consisting of units of K1 -strike
option and (1
) units of K3 -strike option. In this problem, the diversied
portfolio consists of half a 50-strike call and half a 60-strike call.
The expensive asset is the 55-strike call.
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9.10

CONTENTS

Since we cant buy half a call option, well buy 2 units of the portfolio (i.e.
buy one 50-strike call and one 60-strike call). Simultaneously,we sell two 55strike call options.
We use T to represent the common exercise date. This denition works
whether the options are American or European. If the options are American,
well nd arbitrage opportunities if the American options are exercised simultaneously. If the options are European, T is the common expiration date.
The payo is:

Transaction
buy two portfolios
buy a 50-strike call
buy a 60-strike call
Portfolio total

t=0

Sell two 55-strike calls

Total

2 (14) = 28
0:5

18
9:5
27: 5

T
ST < 50

T
50

0
0
0

ST
0
ST

50

0
0

0
ST

50

ST < 55
50

T
55
ST
0
ST

ST < 60
50
50

2 (ST 55)
60 ST > 0

27: 5 + 28 = 0:5
ST 50 2 (ST 55) = 60 ST
2ST 110 2 (ST 55) = 0
So we get $0:5 at t = 0, yet we have non negative cash ows at the expiration
date T . This is arbitrage.
The above strategy of buying units of K1 -strike call, buying (1
) units
of K3 -strike call, and selling one unit of K2 -strike call is called the buttery
spread.
We are given the following 3 puts:
Strike
K1 = 50 K2 = 55
Put premium 7
10:75
50 + (1
! = 0:5

K3 = 60
14:45

) 60 = 55
0:5 (50) + 0:5 (60) = 55

Lets check:
P [0:5 (50) + 0:5 (60)] = P (55) = 10:75
0:5P (50) + 0:5P (60) = 0:5 (7) + 0:5 (14:45) = 10: 725
P [0:5 (50) + 0:5 (60)] > :5P (50) + 0:5P (60)
So arbitrage opportunities exist. To arbitrage, we buy low and sell high.
The cheap asset is the diversied portfolio consisting of units of K1 -strike
put and (1
) units of K3 -strike put. In this problem, the diversied portfolio
consists of half a 50-strike put and half a 60-strike put.
The expensive asset is the 55-strike put.
deeperunderstandingfastercalc.com

T
ST

60

ST 50
ST 60
2ST 110
2 (ST
0

55)

9.11

CONTENTS

Since we cant buy half a option, well buy 2 units of the portfolio (i.e. buy
one 50-strike put and one 60-strike put). Simultaneously,we sell two 55-strike
put options.
The payo is:

Transaction
buy two portfolios
buy a 50-strike put
buy a 60-strike put
Portfolio total

t=0
7
14:45
21: 45

Sell two 55-strike puts 2 (10:75)

Total
0:05
21: 45 + 2 (10:75) = 0:05
50 ST + 60 ST = 110 2ST

T
ST < 50

T
50

ST < 55

T
55

ST < 60

T
ST

50 ST
60 ST
110 2ST

0
60
60

ST
ST

0
60
60

ST
ST

0
0
0

2 (55 ST )
ST 50 0

0
60

ST > 0

0
0

2 (55

ST )

21: 45 + 2 (10:75) = 0:05

110 2ST 2 (55 ST ) = 0
60 ST 2 (55 ST ) = ST 50
So we get $0:05 at t = 0, yet we have non negative cash ows at the expiration
date T . This is arbitrage.
The above strategy of buying units of K1 -strike put, buying (1
) units
of K3 -strike put, and selling one unit of K2 -strike put is also called the buttery
spread.

9.11
This is similar to Problem 9.10.
We are given the following 3 calls:
Strike
K1 = 80 K2 = 100
Call premium 22
9

K3 = 105
5

80 + 105 (1
) = 100
! = 0:2
0:2 (80) + 0:8 (105) = 100
C [0:2 (80) + 0:8 (105)] = C (100) = 9
0:2C (80) + 0:8C (105) = 0:2 (22) + 0:8 (5) = 8: 4
C [0:2 (80) + 0:8 (105)] > 0:2C (80) + 0:8C (105)
So arbitrage opportunities exist. To arbitrage, we buy low and sell high.
The cheap asset is the diversied portfolio consisting of units of K1 -strike
option and (1
) units of K3 -strike option. In this problem, the diversied
portfolio consists of 0.2 unit of 80-strike call and 0.8 unit of 105-strike call.
The expensive asset is the 100-strike call.

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10

60

9.11

CONTENTS

Since we cant buy a fraction of a call option, well buy 10 units of the portfolio (i.e. buy two 80-strike calls and eight 105-strike calls). Simultaneously,we
sell ten 100-strike call options.
We use T to represent the common exercise date. This denition works
whether the options are American or European. If the options are American,
well nd arbitrage opportunities if the American options are exercised simultaneously. If the options are European, T is the common expiration date.
The payo is:
T
ST < 80

T
80

0
0
0

2 (ST
0
2 (ST
0
2 (ST

80)

ST < 105

T
ST

105

Transaction
buy ten portfolios
buy two 80-strike calls
buy eight 105-strike calls
Portfolio total

t=0

Sell ten 100-strike calls

Total

10 (9)
6

0
0

Transaction
buy ten portfolios
buy two 80-strike calls
buy eight 105-strike calls
Portfolio total

t=0

T
100

2 (22)
8 (5)
84

2 (22)
8 (5)
84

Sell ten 100-strike calls

10 (9)
Total
6
2 (22) 8 (5) = 44 40 = 84

2 (ST
0
2 (ST

ST < 100

80)
80)

10 (ST 100)
8 (105 ST ) > 0

80)
80)

2 (ST
8 (ST
10ST
10 (ST

80)
105)
1000
100)

84 + 10 (9) = 84 + 90 = 6
2 (ST 80) + 8 (ST 105) = 10ST 1000
2 (ST 80) 10 (ST 100) = 840 8ST = 8 (105 ST )
10ST 1000 10 (ST 100) = 0
So we receive $6 at t = 0, yet we dont incur any negative cash ows at
expiration T . So we make at least $6 free money.
We are given the following 3 put:
Strike
K1 = 80 K2 = 100
Put premium 4
21

K3 = 105
24:8

80 + 105 (1
) = 100
! = 0:2
0:2 (80) + 0:8 (105) = 100
P [0:2 (80) + 0:8 (105)] = P (100) = 21
0:2P (80) + 0:8P (105) = 0:2 (4) + 0:8 (24:8) = 20: 64
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9.12

CONTENTS

P [0:2 (80) + 0:8 (105)] > 0:2P (80) + 0:8P (105)

So arbitrage opportunities exist. To arbitrage, we buy low and sell high.
The cheap asset is the diversied portfolio consisting of units of K1 -strike
option and (1
) units of K3 -strike option. In this problem, the diversied
portfolio consists of 0.2 unit of 80-strike put and 0.8 unit of 105-strike put.
The expensive asset is the 100-strike put.
Since we cant buy half a fraction of an option, well buy 10 units of the portfolio (i.e. buy two 80-strike puts and eight 105-strike puts). Simultaneously,we
sell ten 100-strike put options.
The payo is:
T
ST < 80

T
80

2 (80 ST )
8 (105 ST )
1000 10ST

0
8 (105
8 (105

Transaction
buy ten portfolios
buy two 80-strike puts
buy eight 105-strike puts
Portfolio total

t=0

Sell ten 100-strike puts

Total

10 (21)
3: 6

Transaction
buy ten portfolios
buy two 80-strike puts
buy eight 105-strike puts
Portfolio total

t=0

T
100

Sell ten 100-strike puts

Total

10 (21)
3: 6

2 (4)
8 (24:8)
84

2 (4)
8 (24:8)
84

10 (100

ST )

ST < 100

ST )
ST )

10 (100 ST )
2 (ST 80) 0

ST < 105

T
ST

0
8 (105
8 (105

ST )
ST )

0
0
0

0
8 (105

ST ) > 0

0
0

105

2 (4) 8 (24:8) = 206: 4

2 (80 ST ) + 8 (105 ST ) = 1000 10ST
206: 4 + 10 (21) = 3: 6
1000 10ST 10 (100 ST ) = 0
8 (105 ST ) 10 (100 ST ) = 2 (ST 80)
We receive $3: 6 at t = 0, but we dont incur any negative cash ows at T .
So we make at least $3: 6 free money.

9.12
For two European options diering only in strike price, the following conditions
must be met to avoid arbitrage (see my study guide for explanation):
0 CEur (K1 ; T ) CEur (K2 ; T ) P V (K2 K1 ) if K1 < K2
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12

9.12
0

CONTENTS
PEur (K2 ; T )

a.
Strike
Call premium

PEur (K1 ; T )
K1 = 90
10

P V (K2

K1 ) if K1 < K2

K2 = 95
4

C (K1 ) C (K2 ) = 10 4 = 6
K2 K1 = 95 90 = 5
C (K1 ) C (K2 ) > K2 K1 P V (K2 K1 )
Arbitrage opportunities exist.
To arbitrage, we buy low and sell high. The cheap call is the 95-strike call;
the expensive call is the 90-strike call.
We use T to represent the common exercise date. This denition works
whether the two options are American or European. If the two options are
American, well nd arbitrage opportunities if two American options are exercised simultaneously. If the two options are European, T is the common
expiration date.
The payo is:
T
T
T
Transaction
t = 0 ST < 90 90 ST < 95
ST 95
Buy 95 strike call
4
0
0
ST 95
Sell 90 strike call 10
0
(ST 90)
(ST 90)
Total
6
0
(ST 90)
5
5
We receive $6 at t = 0, yet our max liability at T is
least $1 free money.
b.
T =2
r = 0:1
Strike
K1 = 90
Call premium 10

5. So well make at

K2 = 95
5:25

C (K1 ) C (K2 ) = 10 5:25 = 4: 75

K2 K1 = 95 90 = 5
P V (K2 K1 ) = 5e 0:1(2) = 4: 094
C (K1 ) C (K2 ) > P V (K2 K1 )
Arbitrage opportunities exist.
Once again, we buy low and sell high. The cheap call is the 95-strike call;
the expensive call is the 90-strike call.
The payo is:
T
T
T
Transaction
t=0
ST < 90
90 ST < 95
ST 95
Buy 95 strike call
5:25 0
0
ST 95
Sell 90 strike call
10
0
(ST 90)
(ST 90)
0:1(2)
0:1(2)
Deposit 4: 75 in savings
4: 75 4: 75e
4: 75e
4: 75e0:1(2)
Total
0
5: 80
95: 80 ST > 0 0:80
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9.12

CONTENTS

4: 75e0:1(2) = 5: 80
(ST 90) + 4: 75e0:1(2) = 95: 80 ST
ST 95 (ST 90) + 4: 75e0:1(2) = 0:80
Our initial cost is zero. However, our payo is always non-negative. So we
never lose money. This is clearly an arbitrage.
Its important that the two calls are European options. If they are American,
they can be exercised at dierent dates. Hence the following non-arbitrage
conditions work only for European options:
0 CEur (K1 ; T ) CEur (K2 ; T ) P V (K2 K1 ) if K1 < K2
0 PEur (K2 ; T ) PEur (K1 ; T ) P V (K2 K1 ) if K1 < K2
c.
We are given the following 3 calls:
Strike
K1 = 90 K2 = 100
Call premium 15
10

K3 = 105
6

1
90 + (1
) 105 = 100
=
3
1
2
! (90) + (105) = 100
3
3
2
1
(90) + (105) = C (100) = 10
C
3
3
1
2
1
2
C (90) + C (105) = (15) + (6) = 9
3
3
3
3
1
2
1
2
C
(90) + (105) > C (90) + C (105)
3
3
3
3
Hence arbitrage opportunities exist. To arbitrage, we buy low and sell high.
1
The cheap asset is the diversied portfolio consisting of unit of 90-strike
3
2
call and unit of 105-strike call.
3
The expensive asset is the 100-strike call.
Since we cant buy a partial option, well buy 3 units of the portfolio (i.e.
buy one 90-strike call and two 105-strike calls). Simultaneously,we sell three
100-strike calls.
The payo at expiration T :
Transaction
buy 3 portfolios
buy one 90-strike call
buy two 105-strike calls
Portfolios total

t=0

T
ST < 90

T
90

15
2 ( 6)
27

0
0
0

ST
0
ST

Sell three 100-strike calls

Total

3 (10)
3

0
0

0
ST

deeperunderstandingfastercalc.com

ST < 100
90

ST
0
ST

90

90

T
100

ST < 105
90
90

3 (ST 100)
2 (105 ST ) > 0
14

T
ST

105

ST 90
2 (ST 105)
3ST 300
3 (ST
0

100)

9.13

CONTENTS

15 + 2 ( 6) = 27
ST 90 + 2 (ST 105) = 3ST
27 + 3 (10) = 3
ST 90 3 (ST 100) = 210
3ST 300 3 (ST 100) = 0

300
2ST = 2 (105

ST )

So we receive $3 at t = 0, but we incur no negative payo at T . So well

make at least $3 free money.

9.13
a. If the stock pays dividend, then early exercise of an American call option
may be optimal.
Suppose the stock pays dividend at tD .
Time 0 ... ... tD ... ... T
Pro and con for exercising the call early at tD .
+. If you exercise the call immediately before tD , youll receive dividend
and earn interest during [tD ; T ]
. Youll pay the strike price K at tD , losing interest you could have
earned during [tD ; T ]. If the interest rate, however, is zero, you wont lose
any interest.
. You throw away the remaining call option during [tD ; T ]. Had you
waited, you would have the call option during [tD ; T ]
If the accumulated value of the dividend exceeds the value of the remaining
call option, then its optimal to exercise the stock at tD :
As explained in my study guide, its never optimal to exercise an American
put early if the interest rate is zero.

9.14
a. The only reason that early exercise might be optimal is that the underlying
asset pays a dividend. If the underlying asset doesnt pay dividend, then its
never optimal to exercise an American call early. Since Apple doesnt pay
dividend, its never optimal to exercise early.
b. The only reason to exercise an American put early is to earn interest on
the strike price. The strike price in this example is one share of AOL stock.
Since AOL stocks wont pay any dividends, theres no benet for owning an
AOL stock early. Thus its never optimal to exercise the put.
If the Apple stock price goes to zero and will always stay zero, then theres
no benet for delaying exercising the put; theres no benet for exercising the
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9.15

CONTENTS

put early either (since AOL stocks wont pay dividend). Exercising the put
early and exercising the put at maturity have the same value.
If, however, the Apple stock price goes to zero now but may go up in the
future, then its never optimal to exercise the put early. If you dont exercise
early, you leave the door open that in the future the Apple stock price may
exceed the AOL stock price, in which case you just let your put expire worthless.
If the Apple stock price wont exceed the AOL stock price, you can always
exercise the put and exchange one Apple stock for one AOL stock. Theres no
hurry to exercise the put early.
c. If Apple is expected to pay dividend, then it might be optimal to exercise
the American call early and exchange one AOL stock for one Apple stock.
However, as long as the AOL stock wont pay any dividend, its never optimal
to exercise the American put early to exchange one Apple stock for one AOL
stock.

9.15
This is an example where the strike price grows over time.
If the strike price grows over time, the longer-lived
valuable as the shorter lived option. Refer to Derivatives
We have two European calls:
Call #1 K1 = 100e0:05(1:5) = 107: 788 T1 = 1:5
Call #2 K2 = 100e0:05 = 105: 127
T2 = 1

option is at least as
Markets Page 298.
C1 = 11:50
C2 = 11:924

The longer-lived call is cheaper than the shorter-lived call, leading to arbitrage opportunities. To arbitrage, we buy low (Call #1) and sell high (Call
#2).
The payo at expiration T1 = 1:5 if ST2 < 100e0:05 = 105: 127
Transaction
Sell Call #2
buy Call #1
Total

t=0
11:924
11:50
0:424

T2
0

T1
ST1 < 100e0:05(1:5)
0
0
0

T1
ST1
0
ST1
ST1

100e0:05(1:5)
100e0:05(1:5)
100e0:05(1:5)

We receive $0:424 at t = 0, yet our payo at T1 is always non-negative. This

is clearly an arbitrage.
The payo at expiration T1 = 1:5 if ST2
Transaction
Sell Call #2
buy Call #1
Total

t=0
11:924
11:50
0:424

T2
100e0:05

deeperunderstandingfastercalc.com

ST2

100e0:05 = 105: 127

T1
ST1 < 100e0:05(1:5)
100e0:05(1:5) ST1
0
100e0:05(1:5) ST1 < 0

T1
ST1 100e0:05(1:5)
100e0:05(1:5) ST1
ST1 100e0:05(1:5)
0
16

9.16

CONTENTS

If ST2
100e0:05 , then payo of the sold Call #2 at T2 is 100e0:05
From T2 to T1 ,
100e0:05 grows into 100e0:05 e0:05(T1

T2 )

ST2 .

= 100e0:05 e0:05(0:5) = 100e0:05(1:5)

ST2 becomes ST1 (i.e. the stock price changes from ST2 to ST1 )
We receive $0:424 at t = 0, yet our payo at T1 can be negative. This is not
an arbitrage.
So as long as ST2 < 100e0:05 = 105: 127 , therell be arbitrage opportunities.

9.16
Suppose we do the following at t = 0:
1. Pay C a to buy a call
2. Lend P V (K) = Ke

rL

at rL

3. Sell a put, receiving P b

4. Short sell one stock, receiving S0b
The net cost is P b + S0b
The payo at T is:
Transactions
Buy a call
Lend Ke rL at rL
Sell a put
Short sell one stock
Total

(C a + Ke

t=0
Ca
KerL
Pb
S0b
P b + S0b

rL

).

(C a + Ke

rL

If ST < K

If ST

0
K
ST K
ST
0

ST K
K
0
ST
0

The payo is always zero. To avoid arbitrage, we need to have

P b + S0b (C a + Ke rL ) 0
Similarly, we can do the following at t = 0:
1. Sell a call, receiving C b
2. Borrow P V (K) = Ke

rB

at rB

3. Buy a put, paying P a

4. Buy one stock, paying S0a

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9.17

CONTENTS

The net cost is C b + Ke

The payo at T is:
Transactions
Sell a call
Borrow Ke rB at rB
Buy a put
Buy one stock
Total

rB

P b + S0b .

t=0
Cb
Ke rB
Pa
S0a
C b + Ke

rB

P b + S0b

If ST < K

If ST

K ST
K
0
ST
0

K
K ST
ST
0

The payo is always zero. To avoid arbitrage, we need to have

0
P b + S0b
C b + Ke rB

9.17
a. According to the put-call parity, the payo of the following position is always
zero:
1. Buy the call
2. Sell the put
3. Short the stock
4. Lend the present value of the strike price plus dividend
The existence of the bid-ask spread and the borrowing-lending rate dierence
doesnt change the zero payo of the above position. The above position always
has a zero payo whether theres a bid-ask spread or a dierence between the
borrowing rate and the lending rate.
If there is no transaction cost such as a bid-ask spread, the initial gain of
the above position is zero. However, if there is a bid-ask spread, then to avoid
arbitrage, the initial gain of the above position should be zero or negative.
The initial gain of the position is:
P b + S0b
[C a + P VrL (K) + P VrL (Div)]
Theres no arbitrage if
P b + S0b
[C a + P VrL (K) + P VrL (Div)] 0
In this problem, we are given
rL = 0:003
rB = 0:004
S0b = 168:89. We are told to ignore the transaction cost. In addition, we
are given that the current stock price is 168:89. So S0b = 168:89.
The dividend is 0:75 on August 8, 2011.
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9.17

CONTENTS

To nd the expiration date, you need to know this detail. Puts and calls are
called equity options at the Chicago Board of Exchange (CBOE). The CBOE
website http://www.cboe.com/learncenter/concepts/basics/expiration.
aspx tells us the following:
When do options expire?
Expiration day for equity and index options is the Saturday immediately following the third Friday of the expiration month until
February 15, 2015. On and after February 15, 2015, the expiration
date will be the third Friday of the expiration month.
When is the last day to trade or exercise an equity option?
The day expiring equity options last trade is the third Friday of
the month. This is also generally the last day an investor may notify his brokerage rm of his intent to exercise an expiring equity call
or put. If this third Friday happens to be an exchange holiday, then
the last day of trading for expiring equity options is the day before,
or the third Thursday of the month. Check with your brokerage rm
about its procedures and deadlines for instruction to exercise equity
options.
In 2011, the 3rd Friday of June is June 17; the 3rd Friday of October is
October 21. The option is issued on May 6, 2011.The time to expiration till
June 17 is
42
6=17=2011 5=6=2011
=
T =
365
365
The time to expiration till October 21 is
10=21=2011 5=6=2011
168
T =
=
365
365
Calculating the days between 10=21=2011 and 5=6=2011 isnt easy. Fortunately,we can use a calculator. BA II Plus and BA II Plus Professional have
"Date" Worksheet. When using Date Worksheet, use the ACT mode. ACT
mode calculates the actual days between two dates. If you use the 360 day
mode, you are assuming that there are 360 days between two dates.
When using the date worksheet, set DT1 (i.e. Date 1) as 5=6=2011 by
entering 5.06111; set DT2 (i.e. Date 2) as 10=21=2011 by entering 10.2111. The
calculator should tell you that DBD=168 (i.e. the days between two days is 168
days).
If you have trouble using the date worksheet, refer to the guidebook of BA
II Plus or BA II Plus Professional.
For the expiration date 6=17=2011, dividend is paid after the expiration date;
the dividend is irrelevant. Hence P VrL (Div) = 0:
8=8=2011 5=6=2011
=
For the expiration date 10=21=2011, the dividend time is tD =
365
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9.17

CONTENTS

94
365
P VrL (Div) = 0:75e
K
160
165
170
175
160
165
170
175

Ca
10:15
6:25
3:30
1:43
14:2
11:0
8:20
5:90

Pb
1:16
2:26
4:25
7:40
5:70
7:45
9:70
12:4

(0:003)94=365

= 0:749 4

P VrL (K) = Ke

0:003T

P b + S0b
[C a + P VrL (K) + P VrL (Div)]
1:16 + 168:89
10:15 + 160e 0:003 42=365 + 0 = 4: 478 10 2
2:26 + 168:89
6:25 + 165e 0:003 42=365 + 0 = 4: 305 10 2
4:25 + 168:89
3:30 + 170e 0:003 42=365 + 0 = 0:101 33
7:40 + 168:89
1:43 + 175e 0:003 42=365 + 0 = 7: 960 10 2
5:70 + 168:89
14:2 + 160e 0:003 168=365 + 0:749 4 = 0:138 6
7:45 + 168:89
11 + 165e 0:003 168=365 + 0:749 4 = 0:181 7
9:70 + 168:89
8:20 + 170e 0:003 168=365 + 0:749 4 = 0:124 8
12:4 + 168:89
5:90 + 175e 0:003 168=365 + 0:749 4 = 0:117 9

b. According to the put-call parity, the payo of the following position is

always zero:
1. Sell the call
2. Borrow the present value of the strike price plus dividend
3. Buy the put
4. Buy one stock
If there is transaction cost such as the bid-ask spread, then to avoid arbitrage,
the initial gain of the above position is zero. However, if there is a bid-ask spread,
the initial gain of the above position can be zero or negative.
The initial gain of the position is:
C b + P VrB (K) + P VrB (Div) (P a + S0a )
Theres no arbitrage if
C b + P VrB (K) + P VrB (Div)

(P a + S0a )

For the expiration date 6=17=2011, dividend is paid after the expiration date;
the dividend is irrelevant. Hence P VrB (Div) = 0:
8=8=2011 5=6=2011
=
For the expiration date 10=21=2011, the dividend time is tD =
365
94
365
P VrB (Div) = 0:75e

(0:004)94=365

deeperunderstandingfastercalc.com

= 0:749 2

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9.18

CONTENTS
K
160
165
170
175
160
165
170
175

Cb
10:05
6:15
3:20
1:38
14:1
10:85
8:10
5:80

Pa
1:2
2:31
4:35
7:55
5:80
7:60
9:85
12:55

C b + P VrB (K) + P VrB (Div) (P a + S0a )

10:05 + 160e 0:004 42=365 + 0 (1:2 + 168:89) = 0:113 6
6:15 + 165e 0:004 42=365 + 0 (2:31 + 168:89) = 0:125 9
3:2 + 170e 0:004 42=365 + 0 (4:35 + 168:89) = 0:118 2
1:38 + 175e 0:004 42=365 + 0 (7:55 + 168:89) = 0:140 5
14:1 + 160e 0:004 168=365 + 0:749 2 (5:80 + 168:89) = 0:135 1
10:85 + 165e 0:004 168=365 + 0:749 2 (7:60 + 168:89) = 0:194 3
8:10 + 170e 0:004 168=365 + 0:749 2 (9:85 + 168:89) = 0:203 5
5:80 + 175e 0:004 168=365 + 0:749 2 (12:55 + 168:89) = 0:212 7

9.18
Suppose there are 3 options otherwise identical but with dierent strike price
K1 < K2 < K3 where K2 = K1 + (1
) K2 and 0 < < 1.
Then the price of the middle strike price K2 must not exceed the price of a
diversied portfolio consisting of units of K1 -strike option and (1
) units
of K2 -strike option:
C [ K1 + (1
P [ K1 + (1

) K3 ]
) K3 ]

C (K1 ) + (1
P (K1 ) + (1

) C (K3 )
) P (K3 )

The above conditions are called the convexity of the option price with respect
to the strike price. They are equivalent to the textbook Equation 9.19 and 9.20.
If the above conditions are violated, arbitrage opportunities exist.
K
80
85
90
170 =

T
0:271 2
0:271 2
0:271 2

Cb
6:5
3:2
1:2

(165) + (1

Ca
6:7
3:4
1:35

K
165
170
175

) 175

Cb
6:15
3:2
1:38
!

Ca
6:25
3:3
1:43

= 0:5

a:
We buy a 165-strike call and a 175-strike call form a diversied portfolio
of calls; simultaneously, we sell two 170-strike calls. The net receipt should be
non-positive, since the payo of the diversied portfolio of calls is always at
least as good as the payo of two 170-strike calls. Otherwise, arbitrage exists.
The net receipt is 2 (3:2) (6:25 + 1:43) = 1: 28, which is non-positive. So
the convexity condition is met.
b.
We sell a 165-strike call and a 175-strike call; simultaneously, we buy two
170-strike calls. The net receipt should be non-negative, since the payo of the
diversied portfolio of calls is always at least as good as the payo of two 170strike calls. Otherwise, arbitrage exists.
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21

10.1

CONTENTS

The net receipt is (6:15 + 1:38)

the convexity condition is met.

2 (3:3) = 0:93, which is non-positive. So

c. To avoid arbitrage, the following two conditions must be met:

C [ K1 + (1
) K3 ]
C (K1 ) + (1
) C (K3 )
P [ K1 + (1
) K3 ]
P (K1 ) + (1
) P (K3 )
These conditions must be met no matter you are a market-maker or anyone
else buying or selling options, no matter you pay a bid-ask spread or not.

10.1
The stock price today is S = 100. The stock at T is either
Su = uS = 1:3

100 = 130

Sd = dS = 0:8

100 = 80

a. For a call, the payo at T is

Vu = max (0; Su

K) = max (0; 130

Vd = max (0; Sd

K) = max (0; 80

105) = 25
105) = 0

We hold a replicating portfolio (4; B) at t = 0. This portfolio will have

value Vu if the stock goes up to Su or Vd if the stock goes down to Sd . We set
up the following equations:
4Su + BerT = Vu
4130 + Be0:08(0:5) = 25
!
rT
4Sd + Be = Vd
480 + Be0:08(0:5) = 0
! B = 38: 431 6
4 = 0:5
So the option premium is:
V = 4S + B = 0:5 100 + ( 38: 431 6) = 11: 568 4
b. For a put, the payo at T is either
Vu = max (0; K

Su ) = max (0; 105

130) = 0

Vd = max (0; K

Sd ) = max (0; 105

80) = 25

We hold a replicating portfolio (4; B) at t = 0. This portfolio will have

value Vu if the stock goes up to Su or Vd if the stock goes down to Sd . We set
up the following equations:
4Su + BerT = Vu
4130 + Be0:08(0:5) = 0
4Sd + BerT = Vd
480 + Be0:08(0:5) = 25
B = 62: 451 3
4 = 0:5
So the option premium is:
V = 4S + B = 0:5 100 + 62: 451 3 = 12: 451 3
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