HW 6 SOLUTIONS - TO PROBLEM SET FOR MODULE 7

7. The current price of the common stock of Internet Enterprises is $100. Over the course
of a year, the stock's price will either increase by 100% or decrease by 50%. The stock
pays no dividends. The current prices of one-period and two period zero coupon risk
free bonds are $909.09 and $826.45 respectively ($1000 face value and the period here is
6 months).

A special European option has recently been created on the common stock of Internet
with the following terms: On the expiration date the holder of the option has the right
to sell the underlying asset for the highest stock price that occurred during the life of
the option inclusive of the date on which it was issued. What is the current value of this
newly issued option on Internet Enterprises? Consider a two-period binomial tree.

The prices of the bonds are given so that we can calculate term structure of interest rates, because
risk-free rate in this problem does not stay constant. Therefore we should discount cash flows of
time 1 using the first element of the term structure r 1 and cash flows of time 2 using the second
element, r2:

1+r 1 =1000/909 .9
r 1 =0 .099
( 1+r 2 )2=1000/826 . 45
r 2 =√ 1000/826 . 45−1=0 .1
2
( 1+r 2 ) 1 .21
1+ 1 f 1 = = =1 .1
1+r 1 1 .099

In this problem u = 2 and d = 0.5. The evolution of the stock price and the payoff of the option (it is
some kind of put) is given by the following three:

Suu = 400
Puu = max{0, 400-400}=0

Su = 200
Sud = 100
Pud= max{0, 200-100}= 100
S=100
Sdu = 100
Sd = 50 Pdu = max{0, 100-100}=0

Sdd = 25
Pdd= max{0, 100-25}= 75

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Now let us calculate the expected payoffs of the option at time 1. First we have to calculate the risk-
neutral probability between times 1 and 2. In this problem risk-neutral probability depends on time
because risk-free rate changes:

Rf 2 −d 1+0 .1−0 .5
PRN 2 = = =0 . 4
u−d 2−0 . 5
Pu =( 0 . 4×0+0 . 6×100 ) /1 . 1=54 . 55
Pd =( 0 . 4×0+ 0 .6×75 ) /1 .1=40 . 91

where the Rf2 is the discount rate between periods one and two and is equal to the forward rate 1f1. Now,
we calculate the price of the option at time 0. Again, first we calculate the risk-neutral probability
between times 0 and 1:

Rf 1 −d1+0 .099−0 .5
PRN 1 = = =0 . 3993
u−d 2−0 . 5
Pu =( 0 .3993×54 .55+0 .6007×40 . 91 ) /1. 099=$ 42. 18
where Rf1 is just equal to r1.

8. A stock is presently selling for $100. Over each of the next two months, the stock will
either increase of decrease in value by 9%, and will not pay any dividends. The risk-free
rate is 2% per month. Consider a call option on the stock with an exercise price of $90
and a maturity date two months hence:

u=1 .09;d=0 .91; r f =0. 02 ;E=$90

(a) What is the value of the option if it is an American option? What is the value if it is a
European option?

(b) What position in stocks and bonds at time zero will have the same value as the call at t
= 1.

(c) If the expected return on the stock is 4% per month, what must the expected return
on the call be over the first month? What will the expected return on the call be in the
second month given that the stock has fallen to $91?

(a) Let us first consider the American option. It can be exercised on any day prior to the expiration and
at the expiration. Therefore, it can be exercised at time 2 (expiration), time 1 and time 0 (now). The
payoffs of the stock and the option are presented below:

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 u 118.81
Cuu =max { 0 , 118.81−90 } =28. 81

u=1.09 109
d 99.19
Cud =max {0 , 99 . 19−90 }=9 .19
S=$100 u 99.19
C du=9 .19
d=0.91 91

d 82.81
C dd=0

The risk neutral probability is:

pRN =R f ¿ ( per ¿ )( trading¿ ) ¿ ¿¿¿ ¿

¿
¿
If we exercise at time 2 (i.e. wait until expiration), the payoff of the call is:

0 . 5093 Cuu +0 . 4907 Cud 0 . 5093 ( 28. 81 ) +0 . 4907 ( 9 .19 )

Cu = = =19 .15
Rf 1 . 0017
0 .5093 C du +0 . 4907 Cdd 0 . 5093 ( 9. 19 ) +0 . 4907 ( 0 )
C d= = =4 .67
Rf 1 . 0017
0 .5093 C u +0 . 4907 C d 0 . 5093 ( 19. 15 ) +0 . 4907 ( 4 . 67 )
C= = =$ 12. 03
Rf 1 . 0017

So if you wait until the expiration the value of the call at time 1 in state “up” is $19.15. If time 1 comes
and you find yourself in the state “up” it does not pay to exercise your call at that time. If you do so your
payoff will be max(0, 109-90) = $19. But this is less than $19.15. In the state “down” if you exercise at
time 1, your payoff is $1, which is again smaller than $4.67, a payoff if you wait until time 2. Now, if
you exercise at time 0, your payoff is $10, but this is again smaller than $12.03, which is the value of the
call, exercised at expiration. We just confirmed what is stated in the notes: it is never optimal to exercise
a call option prior to the expiration if the underlying stock pays no dividend. Therefore, the value of the
American and European call options is the same -- $12.03.

(b) The replicating portfolio of stock and bonds should mimic the payoff of the call in every state. That
is:

uS Δ+R f B=Cu

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 dS Δ+R f B=C d
Solve for delta and B as in the notes:
C u−C d19 .15−4 . 67
Δ= = =.804
( u−d ) S ( 1. 09−. 91 )∗100
uC −dC u 1 .09×4 .67−. 91∗19 . 15
B= d = =−$ 68 . 41
( u−d ) R f ( 1 .09−. 91 )×1 .0017
You should buy 0.804 shares and borrow $68.41

( c) To answer this question, we will need to calculate the true (not risk neutral) probability that the price
of the stock will go up. In the notes on binomial pricing the formula for the objective probability is
given by:

exp { μΔt }−d e . 04−. 91

p= = =. 727
u−d 1. 09−.91
where  is the expected return on the stock per year = 0.0412 and t = 1/12.

Let the expected return on the call be denoted as E[rcall], then

19 .15−12. 03 4 . 67−12. 03
E [ r call ]= p ( r up down
call ) + ( 1− p ) ( r call ) =.727 ( 12. 03 )+(1−.723 ) (
12 .03 ) =.26
The same in the “down” state.

9. Consider a stock that provides an expected return of 15% per annum and has a volatility
of 40% per annum. Suppose that a time interval of .01 year is used for the binomial model,
Calculate u, d, and p. Show that they give correct values for the expected return and the
variance of return during the time interval. Suppose the stock price starts at $50. What
are the possible stock prices at the end of .03 year? What is the probability of each one
occurring?
In this problem again we need to find the objective, not risk neutral probability
u=exp { ο √ Δt }=exp {. 4 √. 01 } =1. 04
d=1/1 . 04=. 96 ,
exp { μΔt }−d exp {. 15×. 01 }−. 96
p= = =. 51
u−d 1. 04−. 96
uS−S dS−S
E(r )= p + ( 1− p ) =.51×(. 04 )+. 49×(−. 04 )=. 0015
S S ,
which is in agreement with 15% annual expected return.

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 σ 2.01 year =.51(.04−. 0015 )2 +.49(−.04−. 0015 )2=.0016
σ 2year =100 σ 2.01 year =.14 by independence of returns
σ year =. 4
u3S=56.37 with p=(.51)3=.132

u2S
u2dS= 52.04 with p=(.51)2(.49)=.127
uS u2dS = 52.04 with p = .127
udS
ud2S= 48.04 with p = .51(.49)2=.124
50 duS u2dS= 52.04 with p = .127

dS ud2S= 48.04 with p = .124

ud2S= 48.04 with p = .124

d2S

d3S= 44.35 with p = (.49)3 = .119

10. Assume a stock pays no dividends and is presently selling for $80. The continuously
compounded return on the stock ln(St/So), is distributed N ( μt , σ √ t ) , with  = 25% per
annum and 2 = 16% per annum. The risk free rate is 14% per annum.
(a) Use the Black Scholes model to value a call option on the stock with an exercise price of
$75 and a maturity date 3 months hence.
S = $80, E = $75, T =1/4 yr, 2 = .16
(b) If you wished to replicate the payoff from the call by continually adjusting a position in
the stock and a position in bonds, what position should you take today?
(c) If the stock were to decrease in value overnight by $1.00, by how much would the call
change in value?
(a)
ln ( 80/75 ) + ( 0 . 14+0 . 5 ( 0 .16 ) )×0 . 25
d1= =. 5977
0 . 4 √ 0 .25
N (d 1 )=0 .7249
d 2 =.5977−0 . 4 √ 0 . 25=. 3977
N (d 2 )=0 .6546
C=80×0. 7249−e−0. 14×0. 25×75×0 . 6546=$ 10 .59

(b) The price of the call is the price of the replicating portfolio C=ΔS + B from our first
−r f T
interpretation of call valuation. By analogy C=SN ( d 1 ) −e EN ( d 2 ) . Therefore N (d 1 ) can be

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 interpreted as a fraction of a share purchased to replicate the payoff to a call (). Since N (d 1 ) < 1,
−r f T
we know it is a fractional share. The term e EN ( d 2 )
can be interpreted as an amount borrowed,
−r f T
this can be viewed as PV amount to be paid at expiration -- e E -- multiplied by the probability
N ( d 2)
of exercise in a risk-neutral world -- . Therefore the replicating portfolio is

Δ=N (d 1 )=0 . 7249 shares

−. 14×( . 25)
B=e ×75×( 0 .6546 )=$ 47 . 18
borrowed to help finance the share repurchase.

( c) The change in the price of the call with respect to the change in the price of the stock (an
underlying asset) is given by:

∂C ( S , T , E )
=Δ=N ( d 1 )=. 7249
∂S ,
which means that if the price of the underlying asset changes (decreases) by $1, the call’s price
decreases by $.72

14. Consider the following type of equity related contract. In exactly one year’s time if the
price of BBN Inc. Stock is between $30 and $60, you must pay the then going spot price to
buy the stock. If the stock’s price is above $60, you must pay an amount given by the
formula:

60+.1(S-60)

where S is the stock’s price (S  $60). If the stock is below $30, then you must pay $30.

a. Draw a diagram showing the amount you must pay for the stock when the contract
matures. Ignore the initial cost of the contract.
b. You can construct this payoff by buying stock plus different options. Identify the
options.
c. Divide the one year time to expiration into two sub-periods of 6 months each. Assume
a binomial process for the underlying stock. You have the following information:

(i) the annualized (not continuously compounded)risk free rate of interest is

5.85%.
(ii) the volatility of the underlying asset (S.D. of its continuously compounded
ROR) is 35% per year.
(iii) The current price of the stock is $45.

What is the value of a contract?

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 d. How would you redesign this contract so that the net value of the options is zero?
(Give a qualitative answer).

Payoff Table:

Price at expiration ST < 30 30 < ST <60 60< ST

Payoff 30 ST 60+0.1(ST-60)=0.1 ST +56

Payoff diagram:

Payoff

60

30

30 60 Price at expiration

b.

This payoff can be replicated with the following portfolio:

{long 1 share, long 1 put with exercise price $30, write 0.9 call with exercise price $60}

Payoff table:

Position ST < 30 30 < ST <60 60< ST

Long 1 share ST ST ST
Long 1 put X=30 30- ST 0 0
Write 0.9 call X=60 0 0 -0.9(ST -60)
Total 30 ST 0.1 ST +54

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c.

u=eσ √T =e 0. 35 √0 . 5=1 . 281

1
d= =0 . 781
u
Rf =1. 0293
R f −d 1. 0292−0. 781
pRN = = =0 . 496
u−d 1. 281−0. 781

19 Consider the binomial approximation to a geometric Brownian motion process on a

stock's return. The stock has an annualized expected rate of return of 12%, and an
annualized volatility of 30%. Suppose our approximation assumes a period of t=.04
year (=2 weeks); what is the distribution of prices in one period under the binomial
model? After 2 periods; after 3 periods? The current price of the stock is $50.

u=e.3 √.04=1. 06
d=1/u=.94
The price distribution after one period

53.09

50

47.09

After two periods

u 56.37

u=1.06 53.09
d 50
S=$50 u 50
d=0.94 47.09

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 d 44.35

After three periods:

59.86

u 56.37 53.09

u=1.06 53.09 53.09

d 50 47.09
S=$50 u 50 53.09
d=0.94 47.09 47.09
47.09
d 44.35
41.76

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