Scribd
Upload
58 views

MT 2 Sol

This document contains the solutions to a second midterm exam for a financial economics course. It includes solutions to 4 questions about option pricing, arbitrage opportunities, and hedging using binomial and Black-Scholes models. Key details calculated include parameters for a binomial model, prices and hedging components for a European call option, and the Black-Scholes price for an option paying the log of the stock price.

Uploaded by

samihav_1
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
58 views

MT 2 Sol

This document contains the solutions to a second midterm exam for a financial economics course. It includes solutions to 4 questions about option pricing, arbitrage opportunities, and hedging using binomial and Black-Scholes models. Key details calculated include parameters for a binomial model, prices and hedging components for a European call option, and the Black-Scholes price for an option paying the log of the stock price.

Uploaded by

samihav_1
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 3

York University Faculty of Science and Engineering MATH 2281 3.00MW Financial Economics Instructor: T.

. Salisbury Second Midterm Examination Solutions March 18, 2011

NAME: SIGNATURE: STUDENT NUMBER: Instructions: (1) You have 50 minutes to complete this exam. (2) There are 4 questions on 6 pages, worth a total of 80 points. If you run out of room, use the back of the page. (3) You may use calculators and may refer to a formula sheet (a letter-size sheet with writing on either side). You may not refer to other notes, books, or use wireless internet devices. (4) Show your work, and explain or justify your solutions if possible. You may leave numerical answers unsimplied. (5) A table of the normal cdf is included. When using it, you may use the closest table value rather than interpolating. Even if your calculator has function keys for the normal distribution, you are expected to use the normal table provided. (This is to ensure an even playing eld.) (6) All interest rates are per year (continuously compounded). 1. You observe a stock trading for $90, and a European call option (strike $95 and expiring in 2 years) trading for $12. There are no dividends on this stock, and the risk-free interest rate is 6%. (a) [10] Given this, what price should a European put with the same strike and expiration trade at? (b) [10] If you see this put trading for $7, how do you create a (static) arbitrage? Explain the cash ows now and in 2 years. Solution: (a) By put call parity, P = C + KerT S = 12 + 95e.062 90 = 6.26
1

(b) Since 6.26 < 7, we sell the put and buy the osetting position C + KerT S. In other words, we go short the put, short the stock, long the call and long a bond paying K at time T . The cash ow at time 0 is 7 + 90 12 95e.062 = 0.74; We pocket this as arbitrage prots, and the positions all cancel out at time T leaving no net cash ow then. [Alternatively, we could have 0 cash ow at time 0 by going short the put, short the stock, long the call and investing the balance of 85 in bonds; 7 + 90 12 85 = 0. Then at time T there is a net positive cash ow of (95 x)+ x + (x 95)+ + 85e.062 = 0.84, regardless of the spot price x.] 2. [10] With a binomial model, should a European put with strike $80 cost more or less than a European put with strike $90? Use risk-neutral valuation to justify your answer. Solution: The put with strike 90 should cost more than the put with strike 80. This is because the put payo f (x) = (K x)+ increases with the strike, so the price 1 v = Rn EQ [f (ST )] does as well. Any other price will give an arbitrage. 3. You are working for an investment bank, which writes a European call option expiring in 18 months with strike $100. It is based on a stock with volatility 30% and current stock price $120. There will be no dividends during this period. The risk free rate is 5%. Your job is to hedge your rms risk. You choose to use a 9 period binomial model for both pricing and hedging. (a) [10] What parameters u and d will you use (assuming the CRR calibration that was analyzed in class)? (b) [20] You calculate that the target values for you hedging portfolio, 2 months after writing the option, are $44.91 if the stock goes up; $21.09 if the stock goes down. Based on this, what price will you charge for the option? Calculate the components of the hedging portfolio you set up at time 0. (c) [10] Now compute the initial Black-Scholes-Merton price for this option. Solution: (a) u = e t = e0.3 1.5/9 = 1.130 and d = e0.3 1.5/9 = 0.885 Cu Cd 44.91 21.09 (b) = = = 0.8102 and S(u d) 120(1.130 0.885) uCd dCu 1.13 21.09 0.885 44.91 B = rT /n = = 64.415 e (u d) e0.051.5/9 (1.130 0.885) In other words, we charge S + B = 0.8102 120 64.415 = 32.810 for the

option, borrow a further 64.415, and use those funds to purchase 0.8102 units of the stock. (c) The BSM price uses d1 = [ln(S/K) + (r + 2 /2)T ]/ T 0.32 = [ln(120/100) + (0.05 + ) 1.5]/(0.3 1.5) = 0.884 2 and d2 = d1 T = 0.517 to give a price of v0 = S(d1 ) KerT (d2 ); Since were using the table, we round o d1 and d2 to 2 decimals, and get v0 = 120(0.88) 100e0.051.5 (0.52) = 120 0.8106 100e0.051.5 0.6985 = 32.469 4. [10] A log-option with expiration T pays $ ln(ST ), where $ST is the price of the underlying stock at time T . Find the Black-Scholes-Merton price of such an option, if the current price of the stock is $60, the risk-free interest rate is 4%, the volatility is 20%, and the option expires in 6 months. Solution: Let Z N (0, 1). Then since E[Z] = 0, the BSM price (in $) is v0 = erT E ln(Se(r
2 )T + 2

TZ

= erT E ln(S) + (r = erT ln(S) + (r = 4.023

2 )T + T Z 2

2 0.22 )T = e0.040.5 ln(60) + (0.04 ) 0.5 2 2

You might also like