John F.

Welch College of Business

Sacred Heart University

MFIM 642 DERIVATIVES AND RISK MANAGEMENT: Spring 2016
8.

(Two-Period Binomial Model) a.

S 45, Su 45(1.10) 49.5, Su 2 45(1.10)2 54.45
Sd 45(.9) 40.5, Sd 2 45(.9)2 36.45
Sud 45(1.10)(.9) 44.55

b.

C u 2 Max(0,54.45 40) 14.45

C ud Max(0,44.55 40) 4.55
C d 2 Max(0,36.45 40) 0
c.

p ((1 r) d)/(u d) (1.05 .9)/(1.10 .9) .75

1 p 1 .75 .25
C u (C u 2 p C ud (1 p))/(1 r)
Cd

(14.45(.75) 4.55(.25))/1.05 11.40

(C ud p C d 2 (1 p))/(1 r)
(4.55(.75) 0(.25))/1.05 3.25

d.
C (C u p C d (1 p))/(1 r)
(11.40(.75) 3.25(.25))/1.05 8.92
e.

h (C u C d )/(Su Sd)
(11.40 3.25) /( 49.5 40.5) .9056
f.

If the stock goes up

h u (C u 2 C ud )/(Su 2 Sud)
MSFIM Assignment 2

(14.45 4.55) /(54.45 44.55) 1

21

Spring 2016

g.

If the stock goes down

h d (C ud C d 2 )/(Sud Sd 2 )
(4.55 0)/(44.55 36.45) .5617

h.

Buy 906 shares and write 1,000 calls

Value of portfolio today:
906(45) 1,000(8.92) = 31,850
Value of portfolio one period later:
If stock goes up,
906(49.50) 1,000(11.40) = 33,447
If the stock goes down,
906(40.50) 1,000(3.25) = 33,443
These two amounts are essentially equivalent.
Return over one period = (33,447/31,850) 1 0.05
If stock goes up to 49.5, hu = 1. Then buy 94 calls at 11.40 for $1,072. Borrow the money at the
risk-free rate. Now you have 906 shares and 906 calls, which is a hedge ratio of 1. Your portfolio
is:
906 shares at 49.50
906 calls at 11.40
loan

=
=
=

44,847
10,328
1,072
33,447

Value of portfolio one period later:

If stock goes up,
906(54.45) 906(14.45) 1,072(1.05) = 35,114
If stock goes down,
906(44.55) 906(4.55) 1,072(1.05) = 35,114
If the stock had gone down in the first period to 40.50, then h d = 0.562. Then sell 344 shares at
40.50. Take the proceeds of 13,932 and invest this amount for the next period in risk-free bonds
earning 5 percent. Now you have 562 shares and 1,000 calls, which is a hedge ratio of 0.562. Your
portfolio is:
MSFIM Assignment 2

22

Spring 2016

562 shares at 40.50

1,000 calls at 3.25
bonds

=
=
=

22,761
3,250
13,932
33,443

Value of the portfolio at the end of the second period:

If stock goes up,
562(44.55) 1,000(4.55) + 13,932(1.05) = 35,116
If stock goes down,
562(36.45) + 13,932(1.05) = 35,114
The difference between 35,114 and 35,116 is due to rounding.
Return over one period =

35,114 / 31,850

1 0.05

If it were overpriced, the investor should establish the same riskless hedge by buying 906 shares
and writing 1,000 calls. If it were underpriced, the investor should buy 1,000 calls and sell short
906 shares. This would create a type of loan in which money is received today and paid back
later. The effective rate on the loan would be less than the risk-free rate.
9.

(Two-Period Binomial Model)

Su =30(1.15)(1- 0.06) =32.43, Sd =30(.9)(1 - 0.06) =25.38

Su2 =32.43(1.15) =37.29, Sd2 =25.38(0.9) =22.84
Sud =32.43(0.9) or 25.38(1.15) 29.19
Cu2 =Max(0, 37.29 - 25) =12.29, Cud =Max(0, 29.19 - 25) =4.19
Cd2 =Max(0, 22.84 - 25) =0
p =(1.05 - 0.9)/(1.15 - 0.9) =0.6
0.6(12.29) +0.4(4.19)
=8.62
Cu =
1.05
but at time 1 in the top state, the stock is at 30(1.15) 34.50 before it goes ex-dividend. So
exercise the call for 34.50 - 25 9.50. Thus, Cu 9.50
0.6(4.19) 0.4(0)
Cd
2.39
1.05
0.6(9.50) 0.4(2.39)
C
6.34
1.05

MSFIM Assignment 2

23

Spring 2016

10.

(Two-Period Binomial Model)

Su 62(1.10) 68.20
Sd 62(.95) 58.90
Su 2 68.20(1.10) 75.02
Sd 2 58.90(.95) 55.96
Sud 68.20(.95) 64.79

p = (1.08 - .95)/(1.10 - .95) = .8667

Pu 2 = Max(0, 70 - 75.02) = 0
Pud = Max(0, 70 - 64.79) = 5.21
Pd 2 = Max(0, 70 - 55.96) = 14.04
Pu =

.87(0) + .13(5.21)
= .63,
1.08

but worth Max(0,70 68.2) = 1.80 if exercised so Pu = 1.80.

Pd =

.87(5.21) + .13(14.04)
= 5.89
1.08

but worth Max(0,70 58.90) = 11.10 if exercised so Pd = 11.10.

P=

.87(1.80) + .13(11.10)
= 2.79
1.08

but worth Max(0,70 62) = 8 if exercised so P = 8.

11.

(Two-Period Binomial Model)

Su 60(1.15) 69
Sd 60(0.80) 48
Su 2 60(1.15) 2 79.35
Sud 60(1.15)(0.80) 55.20
Sd 2 60(0.80) 2 38.40

p (1.10 0.80)/(1.15 0.80) .857

C u 2 Max(0,79.35 50) 29.35
C ud Max(0,55.20 50) 5.20
C d 2 Max(0,38.40 50) 0

MSFIM Assignment 2

24

Spring 2016

.857(29.35) .143(5.20)
23.54
1.10
.857(5.20) .143(0.0)
Cd
4.05
1.10
.857(23.54) .143(4.05)
C
18.87
1.10

Cu

23.54 4.05
.928
69 48
29.35 5.20
hu
1.00
79.35 55.20
5.20 0.0
hd
.3095
55.20 38.40
h

At time 0, h = 0.928. Let us buy 928 shares at 60 and sell 1,000 calls at 18.87. Then the value is
928(60) 1,000(18.87) = 36,810
At time 1 when the stock is 69, the portfolio is worth
928(69) 1,000(23.54) = 40,492
The new hedge ratio is 1.0. Let us buy 72 shares at 69, costing 4,968, which we borrow. Our position is
now 1000 shares, 1000 short calls, and a loan of 4,968.
At time 2 when the stock goes from 69 to 79.35, the portfolio is worth
1000(79.35) 1000(29.35) 4,968(1.10) = 44,535
At time 2 when the stock goes from 69 to 55.20, the portfolio is worth
1000(55.20) 1000(5.20) 4,968(1.10) = 44,535
At time 1 when the stock is 48, the portfolio is worth
928(48) 1,000(4.05) = 40,494
The new hedge ratio is 0.310. Let us sell the shares to generate 618(48) = 29,664 and invest this in bonds.
Our position is now 310 shares, 1000 short calls and 29,664 invested in bonds.
At time 2 when the stock goes from 48 to 55.20, the portfolio is worth
310(55.20) 1,000(5.20) + 29,664(1.10) = 44,542
At time 2 when the stock goes from 48 to 38.40, the portfolio is worth
310(38.40) 1,000(0.0) + 29,664(1.10) = 44,534.
Thus, at time 1 the 36,810 grew to 40,492 (or 40,494, a round off difference), which is 10 %. From time 1,
the 40,492 grew to 44,542 (or 44,535 or 44,534, round off differences), a return of 10%.
MSFIM Assignment 2

25

Spring 2016

12.

(Behavior of the Binomial Model for Large n and Fixed Option Life)
Recall,
, d=1/u, and r = (1+rannual)T/n. Thus the table would be
n
1
5
10
50
100

13.

d
0.5769
0.7819
0.8404
0.9252
0.9465

r
0.07
0.0136
0.0068
0.0014
0.0007

(Extending the Binomial Model to n Periods)

Inserting the proper values into the spreadsheet gives the following:
n
1
5
10
25
50

17.

u
1.7333
1.2789
1.1900
1.0809
1.0565

C
10.4603
9.0585
8.5365
8.7720
8.6721

(One- Period Binomial Model) Recall that the value of p = (1 + r d)/(u d) which in this case equals
51.44%. The hedge ratio varies by the strike price and is 0.743 (X=90), 0.571 (X=100), and 0.400 (X=110).
Thus the hedge ratio declines as the strike price increases, but the probability p does not change.

MSFIM Assignment 2

26

Spring 2016