Scribd
Upload
2 views

Math 366 Winter 2021 Week 8 Assignment Solution

Uploaded by

Dave Hu
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
2 views

Math 366 Winter 2021 Week 8 Assignment Solution

Uploaded by

Dave Hu
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 4

4.

WEEK 8 ASSIGNMENT SOLUTION 101

Math 366 Winter 2021 Week 8 Assignment Solution

E XERCISE 8.1. For a single step binomial tree model (r, u, d, p) repre-
senting a stock for a small time ∆t, the random rate of return to be ln(S∆t /S0 ).
We have connected the average rate of return µ and the volatility σ of the
stock with the parameters of the binomial tree model by
 
S∆t
E ln ≈ µ∆t
S0
and 
S∆t
 √
σ ln ≈ σ ∆t.
S0
Alternatively we can define the average rate of return ν of the stock by
 
S∆t
E ≈ 1 + ν∆t.
S0
It is known that µ = ν − σ2 /2. If we take p = p∗ , what are the average rate
of returns µ∗ and ν∗ under the risk-neutral probability?

S OLUTION . We know that E∗ S∆t = RS0 , where R = 1 + r∆t. From the


definition ν∗ we have ν∗ = r, hence µ∗ = r − σ2 /2.

E XERCISE 8.2. The (annual) interest rate r = 10% and the volatility of
the stock σ = 0.6. Suppose that we model the stock history for one year
by a 24 periods binomial tree model. Assuming the Cox-Ross-Rubinstein
condition, calculate: (1) the upward and downward ratios u and d; (2) the
risk-neutral probability p∗ .

S OLUTION
√ . We have ∆t = 1/24.
√ From the approximate formula u =
1 + σ ∆t = 1.122 and d = 1 − σ ∆t = 0.8775. The approximate value of
the risk-neutral probability
σ2 √
   
∗ 1 1
p = 1+ r− ∆t = 0.48639.
2 σ 2

E XERCISE 8.3. State a version of the central limit theorem and explain
briefly how it is used in constructing a continuous-time model for the stock
price.

S OLUTION . Let { Xn } be a sequence of independent and identically dis-


tributed random variables with mean µ and variance σ and ZN = ∑iN=1 Xi .
Then for large N, the random variable
ZN − Nµ
√
Nσ
102 8. WEEK 8

has approximate the standard normal distribution N (0, 1).


For the N-step binomial tree model under the Cox-Ross-Rubinstein con-
√ stock price at time T is given byN S N = S0 exp(ln u) ZN , where
dition, the
ln u = σ ∆t with ∆t = T/N, and ZN = ∑i=1 with { Xi } independent and
having the identical distribution
P { X1 = 1 } = 1 − P { X1 = − 1 } = p ∗ .
Here p∗ is the risk-neutral probability
σ2 √
   
1 1
p∗ = 1+ r− ∆t .
2 σ 2
Using the central limit theorem we obtain a formula for the stock price

σ2
 √ 
ST = S0 exp r − T + σ TB1 ,
2
where B1 is a random variable with the standard normal distribution N (0, 1).

E XERCISE 8.4. (1) What is the density function of the normal distribu-
tion with mean zero and variance σ2 T? (2) Under the risk-neutral probabil-
ity P∗ , the stock price at time T has the form
σ2
   
ST = S0 exp σBT + r − T .
2
What is the expected value E∗ ST of the stock price at time T?

S OLUTION . (1) The density function for N (0, σ2 T ) is


1 2 /2σ2 T
p( x ) = √ e− x .
2πTσ
(2) This can be done without computation. We know that the price of
an option is always equal to the discounted expectation of the payoff under
the risk-neutral probability. In this case the discount factor is e−rT , hence
S0 = e−rT E∗ ST . Therefore E∗ ST = erT S0 .

E XERCISE 8.5. Suppose that a stock pays dividends. In a single step


binomial tree model, how do you modify the risk-neutral pricing formula
for an option based on this model?

S OLUTION . Let 1/R be the discount factor for the bond and 1/Q the
discount factor for the stock. Let the payoff function be f and f u = f (S0 u)
and f d − f (S0 d). Then the payoff at the end of the period is f u if the stock
is up and f d is the stock is down. Suppose that we start with the portfolio
P(0) = xS0 + y. This portfolio will be xQSu + yR if the stock is up and
4. WEEK 8 ASSIGNMENT SOLUTION 103

xQSo d + yR if the stock is going down. We choose x and y such that the
payoff of the portfolio P is the same as the payoff of the option:
xQS0 u + yR = f u , xQS0 d + yR = f d .
The equations can be solved easily and we have
f u p ∗ + f d (1 − p ∗ )
f0 = ,
R
where the risk-neutral probability is given by
R − dQ
p∗ = .
Q(u − d)

E XERCISE 8.6. Use the Black-Scholes formula for a call option and the
put-call parity to derive the Black-Scholes formula for the corresponding
European put option.

S OLUTION . We have C = SN (d1 ) − Ke−rT N (d2 ). The put-call parity is


C − P = S − Ke−rT . Hence
P = C − S + Ke−rT
= SN (d1 ) − Ke−rT − S + Ke−rT
= Ke−rT [1 − N (d2 )] − S [1 − N (d1 )] .
The density of the standard normal distribution is symmetric with respect
to the origin we have 1 − N (d) = N (−d). Therefore the Black-Scholes
formula for the put option is
P( T; K, S) = Ke−rT N (−d2 ) − SN (−d1 ).

E XERCISE 8.7. The current stock price is $42. Its volatility is 20% per
year. The risk-free interest rate is 10% per year. Use the Black-Scholes for-
mula to compute the price of a six-month European call option with the
strike price $40. You need a normal distribution table.

S OLUTION . We have S0 = 42, σ = 0.2, r = 0.1, T = 1/2, and K = 40.


First we calculate d1 and d2 . We have
ln(S/K ) + (r + σ2 /2) T ln(42/40) + (0.1 + 0.22 /2)(1/2)
d1 = √ = √ = 0.769
σ T 0.2 1/2
and √ √
d2 = d1 − σ T = 0.769 − 0.2 1/2 = 0.628.
Using a normal distribution table we find that
N (d1 ) = 0.7791, N (d2 ) = 0.7350.
104 8. WEEK 8

It follows that
C = S0 N (d1 ) − Ke−rT N (d2 )
= 42 · 0.7791 − 40 · e−0.10/2 · 0.7350
= 32.722 − 27.966
= 4.756.
The price for the call option is $4.76.

You might also like