EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

EF4420 Derivative Analysis and Advanced Investment Strategies

Problem Set 8

This problem set is to be turned in by Wednesday, April 21st 11:00 pm. Please present your work using MS
Word or PDF and submit online on Canvas. You may use Excel for calculation but the final solution should
be presented in MS Word or PDF.

1. American Option on Dividend-Paying Stock

A stock index is currently 810 and the index can increase or decrease by 10% in three months. The dividend
yield on the index is 4% per annum. The risk-free rate is 5% per annum. What is the price of 6-month
American call option with the strike price of 680? Use the two step tree. Is early exercise optimal?

Solution: The risk-neutral probability of upward movement is

e(0.050.04)/4 0.9
p= = 0.513.
1.1 0.9

In six month, the option payoffs are

fuu = max(980.1 680, 0) = 300.1 fud = max(801.9 680, 0) = 121.9 fdd = max(656.1 680) = 0.

In three month, the option values are

 
fu = max 891 680, e0.05/4 ((0.513)(300.1) + (1 0.513)(121.9)) = 211
 
fd = max 729 680, e0.05/4 ((0.513)(121.9) + (1 0.513)(0)) = 61.70

We find that if the stock price increases to $891 in the first three month, early exercise is better than waiting.
The current value of the option is
 
f = max 810 680, e0.05/4 ((0.513)(211) + (1 0.513)(61.70)) = $136.50.

1 Instructor: Yongjin Kim

EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

2. Making Sense of Option Price on the Market

On 7 April 2017, the market prices of call option on Microsoft stock is as follows. These options have
maturity date of 20 October 2017.

[source: Yahoo finance]

We find that the market price of call with strike price of $62.5 is $5.50. Assuming that this option is
European, we want to compare the market price to the theoretical price using a binomial tree. The current
stock price is $65 and the risk-free interest rate is 1%. In constructing the binomial tree, we make the
following assumptions:

We approximate that the time to expiration is six months.

We use a 10-step binomial tree.

(a) To find u and d in the binomial tree, we need the volatility of the stock price. Use historical data on
Microsoft stock price in MSFT.xlsx on Canvas. There, you can find 1-year long observations of daily
stock prices. What is the standard deviation of one-day return? What is the volatility (the standard
deviation of one-year return)?

Solution: From the data, the standard deviation of daily return is 0.01153. Then, the volatility is

0.01153 365 = 0.2202

2 Instructor: Yongjin Kim

EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

(b) What are u and d in the binomial tree? Use the estimated volatility.

Solution: Given that we use a 10-step binomial tree to price the 6-month option, t = (0.5)/10 years.
Then,

u = e0.2202 0.05
= 1.505 d = e0.2202 0.05
= 0.952.

(c) Construct the table showing the possible stock prices and option payoff at the option maturity and their
probabilities as follows:
Solution:

(d) What is the option price?

Solution: The option price is

10
X
e0.010.5 fi probabilityi = $5.594.
i=0

Solution:

3 Instructor: Yongjin Kim

EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

(e) Compare the theoretical price to the market price. Are they close to each other? What can we do to
better estimate the option price?

Solution: The theoretical price, $5.594, is close to the market price, $5.50. To better estimate the
option value, we can try using a binomial tree with more than 10 steps or using the precise value for the
time to expiration.

4 Instructor: Yongjin Kim