Additional questions for chapter 4

1. A stock price is currently $ 100. Over the next two six-month periods it is expected
to go up by 10% or go down by 10%. The risk-free interest rate is 8% per annum
with continuous compounding.
(i) What is the value of a one-year European call option with a strike price of $
100.
(ii) What is the value of a one-year European put option with a strike price of $
100.
(iii) Verify that the European call and the European put satisfy put-call parity.
Solution:
Parameters are u = 0.1, d = 0.1, 1 +r = e
0.50.08
. So the risk-neutral probability is
p

= 0.7. After evaluation of the options at the terminal nodes we use the risk-neutral
valuation to get (i)

C
(0) = e
2(0.50.08)
_
0.7
2
21 + 2 0.7(1 0.7) 0 + (1 0.7)
2
0

= 9.61
and (ii)

P
(0) = e
2(0.50.08)
_
0.7
2
0 + 2 0.7(1 0.7) 1 + (1 0.7)
2
19

= 1.92
(iii) For put-call parity one has to verify S
C
+
P
= Ke
r
, here :
100 9.61 + 1.92 = 100e
0.08
.
2. Assume a standard 3-period CRR binomial model. The price of the stock is currently
$100. The risk-free interest rate with continuous compounding is 6% per annum.
Over the next three 4 month periods, the stock is expected to go up by 8% or go down
by 7% in each period.
(a) What is the value of a one-year European call with strike price $103?
(b) What is the value of a one-year European put with strike price $103?
(c) Verify the Put-Call parity for the European call and the European put.
Solution:
We rst calculate the Martingale probability in the tree. We get
p =
r d
u d
=
e
0.06/3
1 + 0.07
0.08 + 0.07
= 0.6013423
(a) The tree for the call option looks as follows:
time t = 0
S=100
C=6.93
.
.
.
108
10.503
`
`
`
93
1.9022
t = 1/3
.
.
.
116.64
15.679

100.44
3.2272
.
.
.

86.49
0
t = 2/3
.
.
.
125.97
22.97

.
.
.
108.475
5.475

.
.
.

93.409
0
80.435
0
t = 1
(b) The tree for the put option is:
time t = 0
S=100
C=3.936
.
.
.
108
1.46448
`
`
`
93
7.8635
t = 1/3
.
.
.
116.64
0

100.44
3.7477
.
.
.

86.49
14.47
t = 2/3
.
.
.
125.97
0

.
.
.
108.475
0

.
.
.

93.409
9.5908
80.435
22.5643
t = 1
(c) The Put-Call parity holds:
CP = 6.93423.936 = 2.9982 = 100103e
0.06
= 10097.0017 = SKe
rT
.
3. Consider a 3-period Cox-Ross-Rubinstein model. The annual interest rate is r = 0.05
(discrete), u = 0.1 and d = 0.1. The initial price of the stock is S(0) = 100. The
time horizon is T = 3 years.
(a) Calculate the risk-neutral probability and the stock prices at each node in the
binomial tree (correct up to 2 decimal places after the decimal point).
(b) Calculate the value of the European option with payo
P(T) =
_
_
_
sup
0tT
S
t
S
T
S
t
< 110 t
0 otherwise
(c) Find a replicating portfolio for the above option for the rst trading period.
Solution:
(a) For the risk-neutral probability we get p =
rd
ud
=
3
4
. The tree with the stock
prices and the value of the option is
time t = 0
S=100
P=1.25
/
/
/
/
/
/
/
/
/
110
0
\
\
\
\
\
\
\
\
\
90
5.24
t = 1/3
/
/
/
/
/
121
0
`
`
`
`
`
99
0
/
/
/
/
/
99
2.595
`
`
`
`
`
81
14.23
t = 2/3
.
.
.
133.1
0
`
`
`
108.9
0
.
.
.
108.9
0
`
`
`
89.1
0
.
.
.
108.9
0
`
`
`
89.1
10.9
.
.
.
89.1
10.9
`
`
`
72.9
27.1
t = 1
(b) The replicating portfolio can be found by solving the equations
1.05
1
+ 110
2
= 0
1.05
1
+ 90
2
= 5.24
As solution we get
1
= 27.45 and
2
= 0.262.
4. Construct a three period binomial tree using the parameters r = 0.1 (discrete, per
period), u = 0.15, d = 0.05 and S
0
= 100.
(a) Find the price of a European Put P with strike 105 and maturity date T = 3.
(b) Find the price of the knock in Call option C with knock in level H = 110, strike
K = 90 and maturity date T = 3, i.e.
C =
_
(S(T) 90)
+
t : S
t
> H = 110
0 S
t
H = 110 t.
Solution:
The risk neutral probability is
p =
r d
u d
=
0.1 + 0.05
0.15 + 0.05
=
3
4
We rst set up a tree with the stock price movements, then compute the values of
the two options:
time t = 0
S=100
P=0.345
C=31.46
/
/
/
/
/
/
/
/
/
115
0.0625
40.62
\
\
\
\
\
\
\
\
\
95
1.37
16.57
t = 1/3
/
/
/
/
/
132.25
0
50.43
`
`
`
`
`
109.25
0.275
27.43
/
/
/
/
/
109.25
0.275
24.3
`
`
`
`
`
90.25
5.2
0
t = 2/3
.
.
.
152.09
0
62.09
`
`
`
125.64
0
35.64
.
.
.
125.64
0
35.64
`
`
`
103.79
1.21
13.79
.
.
.
125.64
0
35.64
`
`
`
103.79
1.21
0
.
.
.
103.79
1.21
0
`
`
`
85.74
19.26
0
t = 1
5. Assume a 3-period Cox-Ross-Rubinstein model. The annual interest rate with con-
tinuous compounding is r = 0.06. The volatility of the stock is = 0.2 with a price
of S(0) = 100. Furthermore, there exists an American Put with maturity date T = 1
und strike K = 90.
(a) Calculate the risk-neutral probability and the stock prices at each node in the
binomial tree (correct up to 2 decimal places after the decimal point).
(b) Calculate the value of the American Put for all nodes in the tree.
(c) What is the optimal stopping time? Justify your answer.
Solution:
(a) The parameter-values are
=
1
3
, 1+r
d
= e
r
= 1.0202, 1+u = e

= 1.1224, 1+d = e

= 0.8909.
For the risk-neutral probability we get
p

=
r
d
d
u d
= 0.5584.
The tree with the stock prices is
time t = 0
S=100
.
.
.
112.24
`
`
`
89.09
t = 1/3
.
.
.
125.98

89.09
.
.
.

79.38
t = 2/3
.
.
.
141.40

.
.
.
112.24

.
.
.

89.09
70.72
t = 1
(b) The prices for the american Put are
time t = 0
P=2.176
.
.
.
0.17
`
`
`
4.812
t = 1/3
.
.
.
0

0.394
.
.
.

max{10.62, 8.84}
t = 2/3
.
.
.
0

.
.
.
0

.
.
.

0.91
19.28
t = 1
(c) Let = {u, d}
3
. The optimal exercise date is
() =
_
n = 2 {ddu, ddd}
n = 3 otherwise.
For {(ddu), (ddd)}, we have
1
1+r
d
E[p

f
32
+(1 p

)f
33
] < (KS
0
(1 +d)
2
)
+
.
Here f
ij
denotes the price of the claim in period i with j-down movements.
6. Assume that we have a three period CRR model with initial stock price S = $150,
interest rate r = 0.05 and volatility = 0.2.
(a) What is the value of an American Put with strike $150, which matures in 6
months?
(b) What is the value of an American Call with strike $150, which matures in 6
months?
(c) Verify that the following inequalities hold:
S K C
A
P
A
S Ke
rT
Solution:
The martingale probability is p = 0.5308 with u = 0.085, d = 0.0784 and r =
0.0084.
(a), (b) For the American Put and Call we get:
time t = 0
S=150
P
A
=7.57
C
A
=11.01
Z
Z
Z
162.76
2.55
17.78
`
`
`
138.24
13.40
3.54
t = 1/6
Z
Z
Z
176.61
0
27.85
`
`
`
150
5.47
6.72
Z
Z
Z
`
`
`
127.40
22.60
0
t = 2/6
Z
Z
Z
191.63
0
41.63
`
`
`
Z
Z
Z
162.76
0
12.76
`
`
`
Z
Z
Z
`
`
`
138.24
11.76
0
117.41
32.59
0
t = 0.5
(c) We have 0 11.01 7.57 = 3.44 3.7035 = 150 150 e
0.025
7. Show that a security market is arbitrage-free with respect to i it is arbitrage-free
with respect to
a
. Here is the set of all self-nancing trading strategies and
a
is the set of all admissible strategies, that means all with V

(t) 0 t =
0, . . . , T.
Solution:
First note, if
a
is an arbitrage strategy, then it is by denition of
a
also a
strategy in . We now have to show that if we have an arbitrage strategy ,
then there exists an arbitrage strategy
a
.
Assume that is an arbitrage strategy. Then we have V

(0) = 0, P(V

(T)
0) = 1 and P(V

(T) > 0) > 0. We have to distinguish between two cases:

Case 1: V

(t) 0 t = 0, . . . , T. Then
a
and we found the admissible
arbitrage strategy.
Case 2: t

, A F
t
with V

(t

, ) < 0 A and V

(t) 0 t > t

. Then dene
a new strategy . Set (u, ) = 0 A
c
u. Furthermore (u, ) = 0
A and u t

. For the remaining possibilities set

0
(u, ) =
0
(u, )
V

(t

, )
S
0
(t

, )
A u > t

and

i
(u, ) =
i
(u, ) A i = 1, . . . , d u > t

We have to show that this strategy is self-nancing and admissible. For A

c
we clearly have no problem. There is nothing to show for A, u t

. is
also clearly self-nancing for u > t

+ 1 as it just replicates the other strategy

there. We have to show that (t

)S(t

) = (t

+ 1)S(t

). For A we have

0
(t

+ 1)S
0
(t

) =
0
(t

+ 1)S
0
(t

) V

(t

) and
i
(t

+ 1) =
i
(t

+ 1)
Thus we get
(t

+1)S(t

) = 1
A
((t

+1)S(t

)V

(t

)) = 1
A
((t

)S(t

)V

(t

)) = 0 = (t

)S(t

)
It remains to show that is admissible and an arbitrage opportunity. We get
V

(t) = 0 t t

and
V

(t) = 1
A
_
(t)S(t) V

(t

)
S
0
(t)
S
0
(t

)
_
= 1
A
_
V

(t) V

(t

)
S
0
(t)
S
0
(t

)
_
0
and > 0 on A for t = T because V

(t

) < 0. We also have that V

(t) = 0 t t

.
Therefore is admissible and an arbitrage opportunity.
8. (a) State the Black-Scholes formula for an European Call and Put. (Hint: The
Put-Call parity C P = S Ke
r(Tt)
might be useful)
(b) Replicate the European straddle with payo D(T) = |S(T) K| using standard
European options.
(c) What is the Black-Scholes price of the straddle?
(d) What is the of the straddle? How much does the value of the straddle approx-
imately change if the stock price changes from S
t
to S
t
+ ? (Hint: The of
the Call is N(d
1
))
Solution:
(a) The Black-Scholes formula for an European Call and Put is
C(t) = S(t)N(d
1
) Ke
r(Tt)
N(d
2
)
P(t) = Ke
r(Tt)
N(d
2
) S(t)N(d
1
)
where
d
1
=
log(S/K) +
_
r +

2
2
_
(T t)

T t
d
2
= d
1

T t.
(b) We can replicate the straddle D(T) = |S(T) K| by buying one call and one
put, both with strike K.
(c) The Black-Scholes price of the straddle is
D(t) = C(t) + P(t) = S(t)N(d
1
) Ke
r(Tt)
N(d
2
) + Ke
r(T
t
)
N(d
2
) S(t)N(d
1
) =
= S(t)(2N(d
1
) 1) Ke
r(Tt)
(2N(d
2
) 1).
(d) The Delta of the straddle is

D
=
C
+
P
= N(d
1
) N(d
1
) = 2N(d
1
) 1.
When the stock price changes from S
t
to S
t
+ , then the price of the straddle
changes about (2N(d
1
) 1).
9. Consider a nancial market in which the Black-Scholes formula for a European call
option holds. The risk-free interest rate (cont. compounding) is r. The underlying
stock has value S with volatility . For a European call with strike K and maturity
T, show that the following relations hold:
=
C
S
= N(d
1
)
=
C
S
2
=
N

(d
1
)
S

T t
=
C
t
=
SN

(d
1
)
2

T t
rKe
r(Tt)
N(d
2
)
=
C
r
= K(T t)e
r(Tt)
N(d
2
)
=
C

= SN

(d
1
)

T t
Show that the call satises the partial dierential equation
C
t
+rS
C
S
+
1
2

2
S
2

2
C
S
2
rC = 0.
Solution:
We rst show that SN

(d
1
) = Ke
r(Tt)
N

(d
2
):
SN

(d
1
) Ke
r(Tt)
N

(d
2
) =
1

2
_
Se
d
2
1
/2
Ke
r(Tt)
e
d
2
2
/2
_
=
=
1

2
_
Se
d
2
1
/2
Ke
r(Tt)
e
d
2
1
/2+d
1

Tt
2
(Tt)/2
_
=
=
1

2
_
Se
d
2
1
/2
Se
d
2
1
/2
K
S
e
r(Tt)
e
d
1

Tt
2
(Tt)/2
_
=
=
1

2
_
Se
d
2
1
/2
Se
d
2
1
/2
K
S
e
r(Tt)
e
log(S/K)+(r+
2
/2)(Tt)
2
(Tt)/2
_
=
=
1

2
_
Se
d
2
1
/2
Se
d
2
1
/2
_
= 0
Now we calculate the Greeks:
(a)
=
C
S
= N(d
1
) +SN

(d
1
)
d
1
S
Ke
r(Tt)
N

(d
2
)
d
2
S
=
= N(d
1
) + SN

(d
1
)
_
d
1
S

d
2
S
_
=
= N(d
1
)
(b)
=
C
S
2
=

S
= N

(d
1
)
d
1
S
=
N

(d
1
)
S

T t
(c)
=
C
t
= SN

(d
1
)
d
1
t
Ke
r(Tt)
N

(d
2
)
d
2
t
Kre
r(Tt)
N(d
2
) =
= SN

(d
1
)
_
d
1
t

d
2
t
_
Kre
r(Tt)
N(d
2
) =
= SN

(d
1
)

2

T t
rKe
r(Tt)
N(d
2
)
(d)
=
C
r
= SN

(d
1
)
d
1
r
Ke
r(Tt)
N

(d
2
)
d
2
r
+K(T t)e
r(Tt)
N(d
2
) =
= SN

(d
1
)
_
d
1
r

d
2
r
_
+K(T t)e
r(Tt)
N(d
2
) =
= K(T t)e
r(Tt)
N(d
2
)
(e)
=
C

= SN

(d
1
)
d
1

Ke
r(Tt)
N

(d
2
)
d
2

=
= SN

(d
1
)
_
d
1

d
2

_
=
= SN

(d
1
)

T t.
The partial dierential equation holds because:
C
t
+rS
C
S
+
1
2

2
S
2

2
C
S
2
rC =
= SN

(d
1
)

2

T t
rKe
r(Tt)
N(d
2
)+
+rSN(d
1
)+
+
1
2

2
S
2
N

(d
1
)
S

T t
+
+rC =
= r(SN(d
1
) Ke
r(Tt)
N(d
2
) C) = 0.
10. Prove the following limit relations used in the proof of Proposition 3.5.1, assuming
that k
n
(n ):
lim
n
p
n
=
1
2
, lim
n
k
n
(1 2 p
n
)
_

n
= T
_
r

+

2
_
Solution:
We have the following denitions for the variables:

n
=
T
k
n
u
n
= e

n
1
d
n
= e

n
1
r
n
= e
r
n
1
p

n
=
r
n
d
n
u
n
d
n
p
n
= p

n
1 + u
n
1 + r
n
Then, we get for the rst limit relation:
lim
n
p
n
= lim
n
p

n
lim
n
1 + u
n
1 + r
n
. .
1(n)
= lim
n
e
r
n
e

n
e

n
e

n
=
1
2
.
In order to show the last equality, it suces to show that
lim
x0
+
e
rx
2
e
x
e

x e
x
=
1
2
.
as

n
0
+
(n ).
By LHospital we get
lim
x0
+
e
rx
2
e
x
e

x e
x
== lim
x0
+
2xre
rx
2
+e
x
e
x
+e
x
=
1
2
.
For the second limit relation we get:
lim
n
k
n
(1 2 p
n
)
_

n
= lim
n
_
Tk
n
_
1 2
e
r
n
e

n
e

n
e

n
e
r
n
e

n
_
=
= lim
n

T
1 e
2

n
2 + 2e

n
r
n
1

k
n
_
1 e
2

n
_
=

T
_

T
_

2
+
r

__
= T
_

2
+
r

_
.
For the second to last equation it suces to show that:
lim
x0
+
e
2x
1 + 2e
xrx
2
x

T
(1 e
2x
)
=

T
_

2
+
r

_
as

n
0
+
(n ).
We are using LHospital twice and get:
lim
x0
+
e
2x
1 + 2e
xrx
2
x

T
(1 e
2x
)
=
= lim
x0
+

T
2e
2x
2( + 2rx)e
xrx
2
(1 e
2x
) + 2xe
2x
=
= lim
x0
+

T
4
2
e
2x
+ 2( + 2rx)
2
e
xrx
2
4re
xrx
2
2e
2x
+ 2e
2x
4x
2
e
2x
=
=

T
4
2
+ 2
2
4r
4
=

T
_

2
+
r

_
.
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