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IEOR E4706: Financial Eng: Discrete-Time Asset Pricing

Columbia University Instructor: Martin Haugh Outline Solutions to Final Examination Fall 2004 Question 1 (a) $86. (b) Go long a European call option and short a European put option, both with strike F and the same maturity as the forward contract. (c) There is an arbitrage. If the spot rate and T-Bill prices are correct, then the theoretical forward price is 94/.95 = 98.947 which is more than the market price of 95. An arbitrage strategy is to simultaneously buy the forward contact, short copper today and invest the proceeds in 6-month T-Bills. (d) The forward value, F , is given by F = 420(1 + .12/4)2 + .5(1 + .12/4)2 + .5(1 + .12/4) = 446.623.

(e) Since the value of a floating rate bond is par at any reset point, we see that the value of the security is (1 − 1/(1 + s6 )6 ) × 10M. (f ) The forward value, F , is given by F = 9100(1 + .12/2)2 − 500(1 + .12/2) − 500 = 9194.76. (g) Only the third elementary security is attainable. (h) The standard deviations and correlation are irrelevant for the equal-and-opposite hedge! The equal-and-opposite hedge is a long position in (25 × 100, 000)/(30 × 1000) = 83.33 ≈ 83 oil futures contracts. (i) The problem here is one of data-snooping where the analyst continues to mine the data until he finds some “statistically significant” pattern in the data. Such a pattern, however, will rarely be statistically significant when you take into account the fact that the analyst has been systematically looking in the data for patterns. Put another way, even the most random pattern-less data will eventually yield apparent “patterns” if it is mined sufficiently. Question 2 (a) The risk-neutral probability, q , is given by q = (R−d)/(u−d) = (1.01−.9434)/(1.06− .9434) = .5712. 1

F0 .and at node I1 is 3. This was explained in Question 4(a) of Assignment 5. (1 − q )10. Working backwards in the lattice we see that the value of the option at t = 0 is . (b) No.8.4074.525.0658/d(0. Question 3 {2} {1} 6.1809 = 4.7.The put only pays out at the bottom node at t = 3 and then the payout = 10.2745.315) + (1.4074 + 16. at node I1 is 1.9082 = 2.9 price. it also exists at I0 .9 {2} (a) π0 (ω8 ) = π0 (I1 ) × π1 (ω8 ) = .5066)(. (b) A unique futures price does exist. F1 . These prices then imply the unique futures price. The security that pays 1 if the terminal stock price is 106 is worth 0. at I0 is given by Q F0 = E0 [F1 ] = (1. 2) = 2.5066. This is because it exists at each of the time t = 1 nodes.1016 is worth .1350.7. (1) S2 .3524 × . (c) The security that pays 1 if the terminal stock price is 119. This is the unique price of e8 if and only if e8 is attainable.3 4. and the date t = 2 value of the first security. and since the one-period model beginning at I0 is complete.1016 × .3705 = 0.1016 when the terminal stock price is 119.535.0381/R) = 5.0658/.1306. at node I1 is 1. (This was also covered in one of the Assignments.315) + (3. (c) Yes.37) = 2. The value then at the bottom node at t = 2 is max(94 − 88.2613.5327.1809.535)(. there is a unique value for G0 . and 16. you cannot apply put-call parity since this only holds for European options and in this case the value of the American put is not equal to the value of the European put since we saw in part (a) that it was optimal to exercise the American put option early. We expect (and observe that) G0 > F0 since the payoff of the first security appears to be negatively correlated with changes in the short rate.1016.9996. (d) The payoff of the call is 3 when the terminal stock price is 106. 2 .0381. Still the option can be priced simply by working backwards in the lattice as usual and the value is 9.525)(.0004 and it is optimal to exercise the option at that node.8.9014. It so happens that e8 is not attainable and so {2} we cannot say that π0 (ω8 ) is its price. The time t = 1 futures 1. both of which are attainable.2. Part (c) and linear pricing then implies that the call option price is 3 × 0.5 6. This is most easily seen by observing that the payoff of the forward contract is a linear combination of the date t = 2 payoff of a zero-coupon bond with maturity t = 2.) It can be checked (though you did not need to do so) that G0 = 2.

9 (e) First we find the best possible lower bound for this security at node I1 . Since the other one-period models are complete.8. the option payoff is attainable. This is found by solving the following linear program: max θT S subject to Aθ ≤ X where X = [1 2 3 4]T . in states ω6 through (1) ω9 the option always expires in the money and therefore is worth S2 − 1.0815 3 2  1.4045 2.0815 4 1   A=  1. and   1.4917]T .3524y .0815 2 4  . S = [1.8. 3 .7. we have the best arbitrage-free lower bound on the date t = 0 price of X is given by .(d) We can price the option because it is attainable. Since π0 (I1 ) = . 1.7. This payoff is attainable.9 the 3 securities at I1 .3524. 6. In particular.7. The value of the security at the other {1} 6.0815 5 2 Let y be the optimal value of this linear program. being the payoff from a long position in the first security and a short position in the cash account. θ is the 3 × 1 vector of holdings in 6.5 at t = 2.9 two date t = 1 nodes is zero.8.05 3.