SP Jain FIN405 Financial Risk Modelling

Class Discussion Exercises

Topic 6 – Discrete-Time Asset Price Models
These exercises should be attempted after you are familiar with setting up a price process
for binomial lattice models and analysing the summary statistics. You should refer to the
AFIN270 In-Class Spreadsheet Exercises Weeks 6.

Price Processes
1. What comprises a price process?

A price process states how the price of an asset varies over time. It usually contains factors
that determine the trend in the price and also a random variable representing the
unexplained variation and randomness.
2. Explain the difference between a discrete and continuous random variable in terms of the
values they can take.
A discrete random variable can take countably finite range of values. Examples include
the number of cars that are in a major intersection at each red light, the number of trades
that occur for a stock in the financial markets and the number of heads that appear
uppermost in a series of coin tosses.

A continuous random variable can take either an infinite range of values or it is countable
yet infinite because what is measured is not required to be an integer but can take an
arbitrary value. Examples include the height of an individual (countably infinite), the
price paid for a house (infinite range) and the number of passengers that pass through
the terminal of Los Angeles Airport in a year (countably infinite).
3. A random price process is such that the current price is $19.60, with continuously
compounding returns. Assume that the stock price increases with probability 0.45 and
falls with probability 0.55. The annualised stock price volatility is 35%. The price process
is modelled using half-yearly time steps.
a.) Calculate the possible returns on the stock price in one time step.
The stock price changes is determined by:

rU  e 0.35 0.5
 1  28.08%
rD  e 0.35 0.5
 1  21.92%
b.) Show the possible prices for the stock after 2 years.

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 Price
Half-Year 0 1 2 3 4
$19.6000 $25.1037 $32.1530 $41.1816 $52.7455
$15.3029 $19.6000 $25.1037 $32.1530
$11.9479 $15.3029 $19.6000
$9.3284 $11.9479
$7.2833

c.) Calculate the annualised expected return of the stock.

Cumulative Probability
Half-Year 1 2 3 4
0.4500 0.2025 0.0911 0.0410
0.5500 0.4950 0.3341 0.2005
0.3025 0.4084 0.3675
0.1664 0.2995
0.0915
Cumulative Statistics
One Time Step 1 2 3 4
Expected Price $19.7133 $19.8272 $19.9418 $20.0571
Expected Return 0.5779% 1.1592% 1.7439% 2.3319%
Volatility of Price $4.8759 $7.0406 $8.8057 $10.3850
Volatility of Return 24.8768% 35.9216% 44.9273% 52.9849%

The annualised expected return is given by:

1
 $20.0571  2
r  1
 $19.60 
 1.16%

Derivative Pricing, the Law of One Price and the Self-Financing Portfolio
4. A European call option on the stock with a term of one year described in Question 3 has
an exercise price of $20.50. The call option price is being estimated using half-yearly time
steps using a self-financing replicating portfolio comprising a combination of risk-free
bonds that deliver a 5% p.a. return and the stock. Let the bond price at time t be B t and
the stock price be St . The proportion held in the replicating portfolio of the bonds and
stocks at time t be X t and Y t , respectively. The value of the replicating portfolio at time
t (which is also the value of the call option by the law of one price) is denoted as C t . So,
by the law of one price, finding the price of the option can be found by calculating the
value of the replicating portfolio.

a.) Set up an appropriate schedule showing the possible prices for the stock over the next
year.

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 0 1 2
$19.60 $25.10 $32.15
$15.30 $19.60
$11.95

b.) What are the possible values of the option in 12 months’ time, given your answers in
a.)? Show these in an appropriate schedule.

0 1 2
$11.65
$0.00
$0.00

c.) Consider the case where after six months, the stock price increases. The option value
at that date is unknown, but is dependent on the two possible outcomes in the next
six months when the option expires. The replicating portfolio at that time, C 1 , can be
expressed as a combination of bonds and the underlying stock as given below:

C1  X1B0  e0.050.5  YS
1 1

Consider the two possible outcomes for this replicating portfolio after six months
when the option matures and the possible values. By solving simultaneously, what is
the proportion of bonds and stocks held in the replicating portfolio at the start?

The portfolio values if the stock price increases or decreases in the next time step is
given by the following expressions.

We also know that the portfolio value in the next time step is equal to the option
payoff because the option matures at that date:

C1,U  max($32.15  $20.50,0)  X1  B0 e 0.05  Y1  $32.15

C1,D  max($19.60  $20.50,0)  X1  B0 e 0.05  Y1  $19.60

Solve these two equations simultaneously.

X1B0 e 0.05  32.15Y1  11.65 ..1

X1B0 e 0.05  19.6Y1  0.00 ..2
Equation 1 - Equation 2 gives us Y1
12.55Y1  11.65
11.65
Y1 
12.55
Let B0  1 (assume each bond is in $1 units), solve X 1 :
11.65
X1e 0.05  19.6  0
12.55
19.6  11.65
X1  
12.55e 0.05

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 Substituting these proportions of the bonds and stocks to C 1 , we get:

C1  X1e 0.025  Y1  25.10

11.65  19.6 0.025 11.65
 e   25.10
12.55e 0.05 12.55
 $5.5584

d.) Using the same logic, calculate the replicating portfolio after six months when the
stock price decreases, C 2 , by considering the possible outcomes in the next six months
when the option expires.

In the case that the stock price decreases after six months, the stock price in the six
months after that date will be $19.60 and $11.65, respectively. Both cases will result in
the option expiring worthless.
Hence, the replicating portfolio will be worthless.

e.) Using c.) and d.), calculate C 0 , the value of the replicating portfolio today and also
the call option value. This method is known as pricing the option using replicating
portfolios.

The portfolio value in 6 months’ time can be either the following:

C0 ,U  C1  X0 e 0.025  Y0  25.10
C0 ,D  0  X0 e 0.025  Y0  15.30

The values of these portfolios can be solved:

X0 e 0.025  25.1  Y0  4.1763 ..1

X0 e 0.025  15.3  Y0  0 ..2
Equation 1 - Equation 2
9.8Y0  5.584
5.584
Y0 
9.8
5.584  15.3
X0  
9.8e 0.025
Substituting these weights to the original C 0 :

C0  X0  Y0  19.6
5.5584  15.3 5.5584
   19.60
9.8e 0.025 9.8
 $2.437

The stock and bond portfolio weights are as follows:

Stock Bond

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 0 1 0 1
0.567132 0.928304 -8.46449 -17.30738
0.000000 0.00000

The replicating portfolio values are as follows:

0 1 2
$2.6513 $5.5584 $11.6530
$0.0000 $0.0000
$0.0000

f.) Define the pseudo-probability that the stock price would increase, call it q. Define the
value of the call option at time t as C t , the value of the call option in the next time
step should the stock price rise be C tu , and should the stock price fall be Ctd . Explain
why the replicating portfolio value in this case is given by the following expression:

C t  e 0.05  q  C tu   1  q   C td 

It is possible to value the current portfolio as a weighted portfolio of the future

possible portfolio outcomes, discounted back to today. This is a form of an expected
present value technique, because there is a “probability” weighting of q for the
possible outcomes that gives the expected value, and since these are in six months’
time, we discount it back using the risk-free rate.
g.) Now, the expected stock price increase or decrease is not the real-world price increase,
nor is the real-world probability. Rather, the stock price is adjusted for something
called using risk-neutral pricing. We assume that the stock price movements are
weighted to the same measure as the risk-free bond returns. Then, since the risk has
been removed, they can be compared. By the law of one price, the adjusted stock
returns and the bond returns must be the same as they deliver risk-certain cashflows.
Hence, using the risk-neutral probability, q, we can equate the bond returns with the
risk-neutral stock returns. Let St be the stock price at time t, Stu be the stock price at
the subsequent time if the stock price rises and S td be the stock price at the subsequent
time if the stock price falls. Explain the intuition behind this expression and make q
the subject of the formula:

Stu S
  1  q   td
r
Bt e f  q 
St St
By definition, the two assets must deliver the same value using the law of one price.
If one asset yields a higher return than another, it will lead to an arbitrage opportunity.
Note that the price of the bond at any time t is a constant.
Thus, making q the subject of the formula, we do the following steps:

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 r S S  S
e f  q  tu  td   td
 St St  St
r Std S S 
ef   q  tu  td 
St  St St 
rf Std
e 
St
q
 Stu Std 
  
 St St 
Simplifying the ratios to rU and rD ,
r
e f  rD
q
rU  rD

h.) Use f.) and g.) to calculate the value of the option. This method is known as the risk-
neutral pricing of options.

The risk-neutral probability is:

e 0.025  e 0.35 0.5

q  0.48907
e 0.35 0.5  e 0.35 0.5
0 1 2
$2.6513 $5.5584 $11.6530
$0.0000 $0.0000
$0.0000

i.) Show that the replicating portfolio at t = 0 is self-financing in that in each subsequent
time period, the amount of bonds and stocks in the portfolio require no injection of
cash or does not allow withdrawal of cash.

The concept of self-financing is that when the replicating portfolio is set up at t = 0,

the amount you invest to obtain the relevant positions of the bonds and the
underlying stock will have the right value in the subsequent time period for both
possible price outcomes. This allows then the adjustment of the portfolio to replicate
the possible outcomes in the subsequent time period after, all the way till the expiry
of the option.
Recall that at t = 0, the portfolio should be to borrow 8.46449 units of bonds worth $1
each and buy 0.567132 of the stock worth $19.60. This requires an outlay of $2.6513,
the price of the call option.
Should the price rise to $25.1034, the stocks in this portfolio are worth $14.23694 while
the bonds are worth $8.678769, which has to be repaid. The net worth of this portfolio
is $5.5582, difference may be due to rounding.
Now, at this point in time, the required portfolio mix would be to borrow 17.30738
units of the bonds that are now worth $17.745518, and purchase 0.928304 of the stock
worth $25.1034. The value of this is $5.5581, difference is due to rounding.

Applying this to the other time steps should give the same outcomes, proving that the
replicating portfolio must be self-financing.

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