R e v ie w E x e r c is e s

Alessandro Sbuelz

Review .1

Exercise 1
A one-year call option on a stock with a strike price of $30 costs $3; a one-year put option on the stock with a strike price of $30 costs $4. Suppose that a trader buys 2 calls and 1 put. 1. What is the breakeven stock price, above which the trader makes a profit? 2. What is the breakeven stock price, below which the trader makes a profit? If you go long the 2 puts and 1 call, you must spend up front $10. 1. If the 1-year-ahead stock price is $35, then you exercise the 2 calls with a breakeven profit of ($35-$30) x 2 - $10 = $0. Above the $35 level, profit is positive. 2. If the 1-year-ahead stock price is $20, then you exercise the put with a breakeven profit of ($30-$20) x 1 - $10 = $0. Below the $20 level, profit is positive.

Alessandro Sbuelz

Review .2

Exercise 2
Consider a one-period binomial tree model, where the stock price at the beginning of the period is equal to 1000 Euro, and where the stock price in the up-state at the end of the period is equal to 1010 Euro and in the down-state at the end of the period equal to 990 Euro. The period represents a time horizon of one week. The continuously compounded annualized risk free interest rate equals 4%.
Alessandro Sbuelz

Review .3

Exercise 2
A Check that the risk-neutral probability of the upstate equals (approximately) 0.54. B What does it mean if you would find a risk-neutral probability outside the interval (0,1)? C Calculate the fair price of a portfolio consisting of a call and a put option on the stock, both maturing in one week, and both with exercise price equal to 1000 Euro. D E What is the delta of such a portfolio? What is the expected return on such a portfolio ?
Alessandro Sbuelz

Review .4

Exercise 2 (A)
The gross rate of going up is u = 1010/1000 = 1.01 ; The gross rate of going down is d = 990/1000 = 0.99 . The risk-neutral probability of going up is p = ( exp ( r T ) d ) / ( u d ) = ( exp (0.04 (1/52) ) 0.99 ) / ( 1.01 0.99 ) = 0.5384 ~ 0.54
Alessandro Sbuelz

Review .5

Exercise 2 (B)
If p is outside the interval (0,1), there are arbitrage opportunities in the underlying market For example, if p is greater than or equal to 1, one has ( exp ( r T ) d ) / ( u d ) 1 , that is, u . exp ( r T )

Thus, if you short sell the stock for Euro 1000 and put the proceeds in the money market account, you make money for sure : 1000 exp ( r T ) 1000 u 0

Alessandro Sbuelz

Review .6

Exercise 2 (B)
If p is less than or equal to 0, one has that ( exp ( r T ) d ) / ( u d ) exp ( r T ) d .

, that is,

Thus, if you buy the stock for euro 1000 and borrow the money to do so, you make money for sure : 1000 d - 1000 exp ( r T ) 0

Alessandro Sbuelz

Review .7

Exercise 2 ( C )
The call option price is exp ( - r T ) (p 10 + (1 p) 0 ) = Euro 5,38 The put option price is exp ( - r T ) (p 0 + (1 p) 10 ) = Euro 4,61 The portfolio value is
Alessandro Sbuelz

Euro 9,99
Review .8

Exercise 2 (D)
The call option delta calculated today at the spot price 1000 is ( ( + 10 ) 0 ) / ( 1000u 1000d ) = + 0.5

The put option delta calculated today at the spot price 1000 is ( 0 ( + 10 ) ) / ( 1000u 1000d ) = - 0.5

The portfolio is delta neutral, that is, its delta is zero.

Alessandro Sbuelz

Review .9

Exercise 2 (E)
The portfolio is delta neutral so that it must grow at the riskfree rate

Its expected return is the riskfree rate

Alessandro Sbuelz

Review .10

Exercise 3
A European put and a European call with same maturity T and same strike X have the price of p and c respectively. The underlying is a stock that pays no dividends. A Explain why c + p max S 0 Ke

rT

, 0 + max Ke

rT

S 0 ,0

Explain which arbitrage strategy you would implement if you would observe

c + Ke -rT - p < S0
Alessandro Sbuelz

Review .11

Exercise 3 (A)
The no-arbitrage lower bounds imply

c max S 0 Ke

rT

,0

)
)
Review .12

p max Ke rT S 0 , 0

Summing the two inequalities side-wise gives the result

Alessandro Sbuelz

Exercise 3 (B)
c + Ke -rT - p c -p
Sell dear and buy cheap today ! Buy the call Sell the put Sell spot the stock Lend the PV(K) This portfolio yields cash today and its total payoff at T is risklessly zero !
Alessandro Sbuelz

< <

S0 S0 - Ke -rT

Review .13

Exercise 4
A hedge fund needs a derivative contract that is bullish at time T but less than the underlying stock. The underlying stock price is currently S = $10 and is expected to be well above $1 for that date. The underlying stock price is a Geometric Brownian Motion :

dS = S

q ) dt + dz
Alessandro Sbuelz

Review .14

Exercise 4
Payoff at time T

ST
1 1
Alessandro Sbuelz

( ST )

1/2

10

ST Review .15

Exercise 4
The fund buys today (time t) an instrument that pays off the square root of the underlying stock price at time T . Assume that r = 5%, q = 3%, = 25%, and T-t = 0.5 . Given a no-arbitrage assumption, how much will the fund pay for such an instrument ?
Alessandro Sbuelz

Review .16

Exercise 4
The fair price f of the derivative must satisfy the following restrictions :
E risk neutral ( df ) = f r dt f (ST , T ) = ST
1 2

(B - S equation)

(terminal payoff)

f (S s = 0, t s T ) = 0 (bankruptc y leads to zero payoff)

Alessandro Sbuelz

Review .17

Exercise 4
Formulate an educated guess on f !
f (S , t ) = S 2 ,
1

= exp( (T t ))
(terminal payoff is OK)

f (ST , T ) = ST

f (S s = 0, t s T ) = 0 (bankruptcy condition is OK)

Alessandro Sbuelz

Review .18

Exercise 4

You must find the parameter D that makes the guessed f satisfy the B-S equation !

Alessandro Sbuelz

Review .19

Exercise 4
These are f s Greeks :

1 S 2

1 S 2

t =

1 1 S 2 2
1 2

1 S 4

= S

Alessandro Sbuelz

= f
Review .20

Exercise 4
Plug those Greeks into the B-S equation to find out the right parameter D :

(r

)+

fr

1 2

f S

1 f 4 S 2

1 2

(r

q 1 2

1 8

r +

(r

1 4

Alessandro Sbuelz

Review .21

Exercise 4
This is the fair price f the fund will pay today :
f (S = $10, t ) 1 1 1 = 10 2 exp 5% + (5% 3%) 25%2 (0.50) 2 4 = $3.087576
Alessandro Sbuelz

Review .22

Exercise 5
A bank sells today (time 0) a derivative that pays off at time T. It pays the square of the time-T value of an underlying traded stock with current spot price S :

dS S

= dt + dz
Alessandro Sbuelz

Review .23

Exercise 5
Given a no-arbitrage assumption, How much cash does the bank make by selling such a derivative? B What is the value dynamics of the derivative? C Show that the fair price satisfies the Black-Scholes equation D What shall the bank do to offset the risk exposure coming from the derivative sale during the time interval [ 0 , 0+t ] ?
Alessandro Sbuelz

Review .24

Exercise 5 (A)
The fair price of the derivative is given by risk-neutral valuation :
f (S , t = 0 ) = e rT E0
risk neutral

( ST ) ( ST ) + E 0

= e rT var0

risk neutral

risk neutral

( ST )

)]
2

Alessandro Sbuelz

Review .25

Exercise 5 (A)
Given the Geometric Brownian Motion assumption, the expectation and variance of ST are given by (see Ch. 12) :

E 0 ( S T ) = S e T var0 ( ST ) = S 2 e 2 T (e
2

1)
Review .26

Alessandro Sbuelz

Exercise 5 (A)
In riskneutral valuation, you forget about risk premia. Thus, do turn P into the riskfree rate r :

E0

risk neutral

( ST ) = S e rT ( ST ) = S 2e 2 rT (e
Alessandro Sbuelz

var0

risk neutral

1)
Review .27

Exercise 5 (A)
The fair price of the derivative is :
f (S , t = 0 ) = e rT var 0 = e
rT 2

= e rT S 2 e 2 rT e
2

= S e (r + )T
2

[ [S

risk neutral

(ST ) + E0

2 rT

T
2

1 + S 2 e 2 rT

risk neutral

(ST )

)]
2

Alessandro Sbuelz

Review .28

Exercise 5 (B)
df = + S + S 2 f f (r + 2 ) 2 f 2 2 S S

dt + S d z f 2 S

= f r +

( (

)+ 2 f +

)dt + 2 f

dz

= f (2 r )dt + 2 f d z
Alessandro Sbuelz

Review .29

Exercise 5 ( C )
df = f (2 r )dt + 2 f d z E 0risk neutral (df ) = f 2 r r dt IT WAS !

= fr dt

(but this is the B - S equation ! )

Alessandro Sbuelz

Review .30

Exercise 5 (D)
The bank has just sold the derivative It should go long the underlying
'

=2f/S

units of

This will offset the risk exposure coming from the derivative sale in the time interval [ 0 , 0+dt ]
Alessandro Sbuelz

Review .31

Summary
We reviewed the following topics :
Forward and futures prices; Trading strategies based on options; Properties of option prices; Binomial trees; Black-Scholes model
Power derivatives (square root) Power derivatives (square)
Alessandro Sbuelz

Review .32