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Tutorial Solutions Week 9

The document provides solutions to 5 tutorial questions about valuing European options using binomial trees. Question 1 values a 2-month European call option on a stock priced at $50 using both no-arbitrage and risk-neutral valuation approaches, obtaining a value of $2.23. Question 2 values a 3-month European put option on a stock priced at $40 using the same approaches, obtaining a value of $2.05. Question 3 values a 6-month European call option on a stock priced at $50 whose price can rise 6% or fall 5% over each of the next two 3-month periods, obtaining a value of $1.635.

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Jaden Eu
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31 views

Tutorial Solutions Week 9

The document provides solutions to 5 tutorial questions about valuing European options using binomial trees. Question 1 values a 2-month European call option on a stock priced at $50 using both no-arbitrage and risk-neutral valuation approaches, obtaining a value of $2.23. Question 2 values a 3-month European put option on a stock priced at $40 using the same approaches, obtaining a value of $2.05. Question 3 values a 6-month European call option on a stock priced at $50 whose price can rise 6% or fall 5% over each of the next two 3-month periods, obtaining a value of $1.635.

Uploaded by

Jaden Eu
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Tutorial questions week 9 Solutions

Question 1.
A stock price is currently $50. It is known that at the end of two months it will be either $53 or
$48. The risk-free interest rate is 10 percent p.a. with continuous compounding. Using the
binomial tree, compute the value of a two-month European call option with a strike price of $49,
with (a) the no-arbitrage approach, (b) with risk neutral valuation approach.

Answer
Su=53 u=1.06
fu=4

50

Sd=48 d=0.96
fd=0

S= $50, K=$49, r= 0.1, T=2/12


Su=$53 u =53/50=1.06
Sd=$48 d=48/50=0.96
𝑒 𝑟𝑇 −𝑑 𝑒 0.1∗2/12 −0.96
p= = = 0.5681
𝑢−𝑑 1.06−0.96

a) No arbitrage approach
Consider a portfolio consisting of buying Δ shares and selling 1 call option
The value of the portfolio is either 48 Δ or 53 Δ – 4 in two months.
48Δ = 53 Δ – 4 Δ =0.8
Future value of the portfolio $48(0.8) = $53(0.8) – 4 = $38.4
The current value of the portfolio is 0.8(50) – f, where f is the value of the option.
50(0.8) – f = 38.4 e-0.1*2/12 f = 2.23
The value of the option is therefore $2.23.
b) Risk neutral valuation approach
𝑒 𝑟𝑇 −𝑑 𝑒 0.1∗2/12 −0.96
p= = = 0.5681
𝑢−𝑑 1.06−0.96

f  [ pf u  (1  p) f d ]e rT = [0.5681*4+0.4319*0] 𝑒 −0.1∗2/12=2.23


Question 2.
A stock is currently $40. It is known that at the end of three months it will be either $45 or $35.
The risk-free interest rate is 8 percent p.a. Using the binomial tree, compute the value of a three-
month European put option on the stock with a strike price of $40, with (a) the no-arbitrage
approach, (b) with the risk neutral valuation approach.

Answer
Su=45 u=1.125
fu=0

40

Sd=35 d=0.875
fd=5
S= $40, K=$40, r= 0.08, T=3/12=0.25
Su=$45 u =45/40=1.125
Sd=$35 d=35/40=0.875
𝑒 𝑟𝑇 −𝑑 𝑒 0.08∗0.25 −0.875
p= = = 0.5808
𝑢−𝑑 1.125−0.875

a) No arbitrage approach
Consider a portfolio consisting of buying Δ shares and buying 1 put option
The value of the portfolio is either 45 Δ or 35 Δ + 5 in two months.
45Δ = 35 Δ +5 Δ =0.5
Future value of the portfolio $45(0.5) = $35(0.5) +5 = $22.5
The current value of the portfolio is 0.5(40) + f, where f is the value of the option.
40(0.5) + f = 22.5 e-0.0.8*0.25 f = 2.05
The value of the option is therefore $2.05.

b) Risk neutral valuation approach


𝑒 𝑟𝑇 −𝑑 𝑒 0.08∗0.25 −0.875
p= = = 0.5808
𝑢−𝑑 1.125−0.875

f  [ pf u  (1  p) f d ]e rT = [0.5808*0+0.4192*5] 𝑒 −0.08∗0.25 =2.05


Question 3.
A stock price is currently $50. Over each of the next two three-month periods, it is expected to go
up by 6 percent or down by 5 percent. The risk-free interest rate is 5 percent per annum with
continuous compounding. What is the value of a six-month European call option with a strike
price of $51?

56.18
Answer 5.18

B
53
2.91

50 50.35
A 0

C
47.5
0
45.125
0

S= $50, K=$51, r= 0.05, T=3/12=0.25


u =1+0.06=1.06
d=1-0.05=0.95
𝑒 𝑟𝑇 −𝑑 𝑒 0.05∗0.25 −0.95
p= = = 0.5689
𝑢−𝑑 1.06−0.95

fB  [ pf u  (1  p) f d ]e rT = [0.5689*5.18+0.4311*0] 𝑒 −0.05∗0.25 =2.91

fC = 0
fA  [ pf u  (1  p) f d ]e rT = [0.5689*2.91+0.4311*0] 𝑒 −0.05∗0.25=1.635
Question 4.
For the situation considered in question 3 above, what is the value of a six-month European put
option with a strike price of $51? Verify that the European call and European put prices satisfy
put-call parity.

56.18
Answer 0

B
53
0.277

50 50.35
A 0.65

C
47.5
2.866
45.125
5.875

fB  [ pf u  (1  p) f d ]e rT = [0.5689*0+0.4311*0.65] 𝑒 −0.05∗0.25 =0.277

fC  [ pf u  (1  p) f d ]e rT = [0.5689*0.65+0.4311*5.875] 𝑒 −0.05∗0.25=2.866

fA  [ pf u  (1  p) f d ]e rT = [0.5689*0.277+0.4311*2.866] 𝑒 −0.05∗0.25=1.376

Put-call parity c  Ke  rT  p  S

c  KerT  1.635 + 51 ∗ 𝑒 −0.05∗𝟎.𝟓 =51.376


pS = 1.376 + 50 = 51.376
Therefore, the put-call parity holds
Question 5.
What would be the price of the put in Q4 if it were an American put option?

Answer

To incorporate the early exercise feature of an American option, we compare the discounted
value calculated for the option at each node with the payoff from immediate exercise. The
greater is the option value at that node.

At node C the payoff from immediate exercise is 51 – 47.5 = 3.5. Since this is greater than 2.866,
the option should be exercised at this node, hence 3.5 is the option value at this node. The option
should not be exercised early at node B.

The value of the put at current time, node A [0.277*0.5689 + 3.5*0.4311]e-0.05*0.25=1.645

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