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Models and Pricing of Financial Derivatives

Homework 2 Deadline: October 28, 2023

1. A stock price is currently $40. It is known that at the end of 3 months it will be either $45
or $35. The risk-free rate of interest with quarterly compounding is 8% per annum. Calculate the
value of a 3-month European put option on the stock with an exercise price of $40. Verify that
no-arbitrage arguments and risk-neutral valuation arguments give the same answers.

2. Consider the situation in which stock price movements during the life of a European option
are governed by a two-step binomial tree. Explain why it is not possible to set up a position in the
stock and the option that remains riskless for the whole of the life of the option.

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

4. For the situation considered in Problem 3, what is the value of a 6-month European put option
with a strike price of $51? Verify that the European call and European put prices satisfy put-call
parity. If the put option were American, would it ever be optimal to exercise it early at any of the
nodes on the tree?

5. A stock price is currently $25. It is known that at the end of 2 months it will be either $23 or
$27. The risk-free interest rate is 10% per annum with continuous compounding. Suppose ST is the
stock price at the end of 2 months. What is the value of a derivative that pays off ST2 at this time?

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6. A stock price is currently $40. Over each of the next two 3-month periods it is expected
to go up by 10% or down by 10%. The risk-free interest rate is 12% per annum with continuous
compounding.
(a) What is the value of a 6-month European put option with a strike price of $42?
(b) What is the value of a 6-month American put option with a strike price of $42?

7. A stock price is currently $30. During each 2-month period for the next 4 months it will
increase by 8% or reduce by 10%. The risk-free interest rate is 5%. Use a two-step tree to calculate
the value of a derivative that pays off [max(30 − ST , 0)]2 , where ST is the stock price in 4 months.
If the derivative is American-style, should it be exercised early?

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