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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

The risk-neutral probability of going up is p = ( exp ( r × T ) – d ) / ( u – d ) = ( exp (0. The gross rate of going down is d = 990/1000 = 0.1)? C Calculate the fair price of a portfolio consisting of a call and a put option on the stock. if p is greater than or equal to 1.1). you make money for sure : 1000 × exp ( r × T ) – 1000 × u 0 Alessandro Sbuelz Review .01 .5 Exercise 2 (B) If p is outside the interval (0. if you short sell the stock for Euro 1000 and put the proceeds in the money market account. that is. both maturing in one week.54 Alessandro Sbuelz Review .5384 ~ 0.99 ) = 0.4 Exercise 2 (A) The gross rate of going up is u = 1010/1000 = 1.01 – 0. and both with exercise price equal to 1000 Euro. exp ( r × T ) Thus.99 ) / ( 1. D E What is the delta of such a portfolio? What is the expected return on such a portfolio ? Alessandro Sbuelz Review . B What does it mean if you would find a risk-neutral probability outside the interval (0. one has ( exp ( r × T ) – d ) / ( u – d ) 1 .04 × (1/52) ) – 0.54.Exercise 2 A Check that the risk-neutral probability of the upstate equals (approximately) 0.99 . there are arbitrage opportunities in the underlying market For example.6 . u .

if you buy the stock for euro 1000 and borrow the money to do so.38 The put option price is exp ( .7 Exercise 2 ( C ) The call option price is exp ( .5 The put option delta calculated today at the spot price 1000 is ( 0 – ( + 10 ) ) / ( 1000×u – 1000×d ) = .61 The portfolio value is Alessandro Sbuelz Euro 9. that is.1000 × exp ( r × T ) 0 Alessandro Sbuelz Review .0. its delta is zero.9 . Thus. one has that ( exp ( r × T ) – d ) / ( u – d ) exp ( r × T ) d .99 Review .r × T ) × (p × 10 + (1 – p) × 0 ) = Euro 5. you make money for sure : 1000 × d .5 The portfolio is delta neutral. Alessandro Sbuelz Review .8 Exercise 2 (D) The call option delta calculated today at the spot price 1000 is ( ( + 10 ) – 0 ) / ( 1000×u – 1000×d ) = + 0.r × T ) × (p × 0 + (1 – p) × 10 ) = Euro 4.Exercise 2 (B) If p is less than or equal to 0. that is. ¡ ¡ 0 .

0 ) B Explain which arbitrage strategy you would implement if you would observe c + Ke -rT . 0 ( Summing the two inequalities side-wise gives the result Alessandro Sbuelz . A Explain why c + p ≥ max S 0 − Ke ( − rT .p < S0 Alessandro Sbuelz Review . The underlying is a stock that pays no dividends.0 ) ) Review .11 Exercise 3 (A) The no-arbitrage lower bounds imply c ≥ max S 0 − Ke ( − rT .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 .12 p ≥ max Ke − rT − S 0 . 0 + max Ke ) ( − rT − S 0 .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.

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 .15 .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 a Geometric Brownian Motion : dS = S (µ − q )× dt + σ × dz Alessandro Sbuelz Review .14 Exercise 4 Payoff at time T ST 1 1 Alessandro Sbuelz ( ST ) 1/2 10 ST Review .Ke -rT Review .Exercise 3 (B) c + Ke -rT . The underlying stock price is currently S = $10 and is expected to be well above $1 for that date.

and T-t = 0. σ = 25%. t ) = S 2η . Given a no-arbitrage assumption. t ≤ s ≤ T ) = 0 (bankruptc y leads to zero payoff) 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 ≤ s ≤ T ) = 0 (bankruptcy condition is OK) Alessandro Sbuelz Review . how much will the fund pay for such an instrument ? Alessandro Sbuelz Review . Assume that r = 5%.18 .17 Exercise 4 Formulate an educated guess on f ! f (S . T ) = ST 1 2 (B . T ) = ST 1 2 f (S s = 0.5 . q = 3%. 1 η = exp(α × (T − t )) (terminal payoff is OK) f (ST .S equation) (terminal payoff) f (S s = 0.Exercise 4 The fund buys today (time t) an instrument that pays off the square root of the underlying stock price at time T .

20 Exercise 4 Plug those Greeks into the B-S equation to find out the right parameter D : Θ ¢ + ∆ S £ − α f (r − q )+ ½ − Γ ¤ S 2 σ 2 = fr 1 2 f S 1 f 4 S 2 − α + 1 2 (r − q 1 2 )− 1 σ 8 2 = r α = − r + (r − q )− 1 σ 4 2 Alessandro Sbuelz Review .Exercise 4 You must find the parameter D that makes the guessed f satisfy the B-S equation ! Alessandro Sbuelz Review .21 .19 Exercise 4 These are f ‘s Greeks : ∆ t = 1 S 2 1 2 −1 η = 1 S 2 −1 f Γt = 1 1 − S 2 2 1 2 1 2 − 2 η = − 1 S 4 − 2 f Θ t = −α S η Alessandro Sbuelz = −α f Review .

Exercise 4 This is the fair price f the fund will pay today : f (S = $10. 0+δt ] ? Alessandro Sbuelz A Review . It pays the square of the time-T value of an underlying traded stock with current spot price S : dS S = µ × dt + σ × dz Alessandro Sbuelz Review . 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 .24 .087576 Alessandro Sbuelz Review .22 Exercise 5 A bank sells today (time 0) a derivative that pays off at time T. t ) 1 1 1 = 10 2 × exp− 5% + (5% − 3%)− 25%2 × (0.50) 2 4 = $3.23 Exercise 5 Given a no-arbitrage assumption.

you forget about risk premia. do turn P into the riskfree rate r : E0 risk − neutral ( ST ) = S e rT ( ST ) = S 2e 2 rT (eσ Alessandro Sbuelz var0 risk − neutral 2 T − 1) Review .26 Alessandro Sbuelz Exercise 5 (A) In risk–neutral valuation. 12) : E 0 ( S T ) = S e µT var0 ( ST ) = S 2 e 2 µT (eσ 2 T − 1) Review . Thus. the expectation and variance of ST are given by (see Ch.Exercise 5 (A) The fair price of the derivative is given by risk-neutral valuation : f (S .27 . t = 0 ) = e − rT E0 risk − neutral ( ST ) ( ST ) + E 0 2 = e − rT var0 [ risk − neutral ( risk − neutral ( ST ) )] 2 Alessandro Sbuelz Review .25 Exercise 5 (A) Given the Geometric Brownian Motion assumption.

t = 0 ) = e − rT var 0 = e − rT 2 = e − rT S 2 e 2 rT e σ 2 = S e (r + σ )T 2 [ [S [ risk − neutral ( (ST ) + E0 2 T e 2 rT e σ T 2 ] − 1 + S 2 e 2 rT ) ( risk − neutral ] (ST ) )] 2 Alessandro Sbuelz Review .S equation ! ) Alessandro Sbuelz Review .29 Exercise 5 ( C ) df = f (2 µ − r )dt + 2 fσ d z E 0risk − neutral (df ) = f 2 r − r dt IT WAS µ ! ¨ = fr dt (but this is the B .28 Exercise 5 (B) df = Θ + ∆ µ S + ½ Γ S 2σ f − f (r + σ 2 ) 2 f 2 2 S S ¥ ¦ § 2 dt + ∆ σ S d z f 2 S § = − f r +σ ( ( 2 )+ 2 f µ + fσ 2 )dt + 2 fσ dz = f (2 µ − r )dt + 2 f σ d z Alessandro Sbuelz Review .Exercise 5 (A) The fair price of the derivative is : f (S .30 .

32 .Exercise 5 (D) The bank has just sold the derivative It should go long the underlying ' 0 =2f/S units of This will offset the risk exposure coming from the derivative sale in the time interval [ 0 . – Trading strategies based on options. – Black-Scholes model • Power derivatives (square root) • Power derivatives (square) Alessandro Sbuelz Review .31 Summary • We reviewed the following topics : – Forward and futures prices. – Properties of option prices. 0+dt ] Alessandro Sbuelz Review . – Binomial trees.

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