Princeton ECO 363

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Princeton ECO 363

© All Rights Reserved

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EC0 46S

SS2u14

"#$%&'( )'* +,

"#$%&'( -.

1a.

%define variables

S=52;K=50;r= .05; dy = .05;

t=1/2;num_steps=125;dt=t/num_steps;sigma=.25;

%calculate states and probability of up state

u = (exp( (r-dy)*dt + sigma*sqrt(dt)));

d = (exp( (r-dy)*dt - sigma*sqrt(dt)));

p = (exp((r - dy)*dt) - d)/(u-d);

%calculate stock price at each final node

vec = [125:-1:0'];

vec2= [0:1:125'];

ST = S*(u.^vec).*(d.^vec2);

%calculate call payoff at each node and probability of each

node

CPayoff = max (ST-K, 0);

Qprob = binopdf( (num_steps: -1:0)', num_steps, p);

Cprice =exp(-r*t) * (CPayoff*Qprob)

/0&& 1#23' 4,.5678

1b.

%define variables

S=52; K=50; r=.05; d=1.30; exdiv =3/12; t=1/2;

num_steps=125;

dt=t/num_steps;sigma=.25;

%Value of prepaid forward

F = S - d^(-r*exdiv);

%volatility of prepaid forward

sigmaF = sigma * (S/F);

%calculate u and d coefficients and probability of up-state

u = exp( (r*dt + sigmaF*sqrt(dt)));

d = exp( (r*dt - sigmaF*sqrt(dt)));

p = (exp((r*dt)) - d)/(u-d);

%calculate price of prepaid at end of period

vec = [125:-1:0'];

vec2= [0:1:125'];

FT = F*(u.^vec).*(d.^vec2);

CPayoff = max (FT-K, 0);

Qprob = binopdf( (num_steps: -1:0)', num_steps, p);

Cprice =exp(-r*t) * (CPayoff*Qprob)

/0&& 1#23' 4 ,.9:8;

0sing a continuous uiviuenu gave a piice that was 4.S679 4.8u92-1 = S.u2% less

than using a uisciete uiviuenu.

1c.

%define variables

S=52; K=50; r= .05; dy = .075; t=1/3; num_steps=125;

dt=t/num_steps;

sigma=.25;

%calculate state coefficients and probabilities

u = (exp( (r-dy)*dt + sigma*sqrt(dt)));

d = (exp( (r-dy)*dt - sigma*sqrt(dt)));

p = (exp((r - dy)*dt) - d)/(u-d);

%calculate stock price in final nodes

vec = [125:-1:0'];

vec2= [0:1:125'];

ST = S*(u.^vec).*(d.^vec2);

%calculate call payouts and probabilities of payouts at

final nodes

CPayoff = max (ST-K, 0);

Qprob = binopdf( (num_steps: -1:0)', num_steps, p);

Cprice =exp(-r*t) * (CPayoff*Qprob)

/0&& 1#23' 4 <.7-,: =2*> 0 3$?*2?@$@A B2C2B'?B

%define variables

S=52;K=50;r=.05; d=1.30; exdiv =3/12;t=1/3; num_steps=125;

dt=t/num_steps;sigma=.25;

%Value of prepaid forward

F = S - d^(-r*exdiv);

%volatility of prepaid forward

sigmaF = sigma * (S/F);

%calculate u and d coefficients and probability of up-state

u = exp( (r*dt + sigmaF*sqrt(dt)));

d = exp( (r*dt - sigmaF*sqrt(dt)));

p = (exp((r*dt)) - d)/(u-d);

%calculate price of prepaid at end of period

vec = [125:-1:0'];

vec2= [0:1:125'];

FT = F*(u.^vec).*(d.^vec2);

CPayoff = max (FT-K, 0);

Qprob = binopdf( (num_steps: -1:0)', num_steps, p);

Cprice =exp(-r*t) * (CPayoff*Qprob)

/0&& 1#23' 4D <.8,-,

The piice using continuous uiviuenus is S.714uS.9414 - 1 = %S.769S less that

when uisciete uiviuenus aie useu.

Bence the uisciepancy is laigei when the matuiity is shoitei.

1u.

%define variables

S=52; K=50; r=.05; d=1.30; exdiv =3/12; t=1/2;

num_steps=125;

dt=t/num_steps;sigma=.25;

%Value of prepaid forward

F = S - d^(-r*exdiv);

%volatility of prepaid forward

sigmaF = sigma * (S/F);

%calculate u and d coefficients and probability of up-state

u = exp( (r*dt + sigmaF*sqrt(dt)));

d = exp( (r*dt - sigmaF*sqrt(dt)));

p = (exp((r*dt)) - d)/(u-d);

%calculate price of prepaid at end of period

vec = [num_steps:-1:0'];

vec2= [0:1:num_steps'];

FT = F*(u.^vec).*(d.^vec2);

%create Call payoff vector equal to normal call payoff if

FT is less

%than 70 and zero if FT is greater than zero

CPayoff = [0:num_steps];

for i = 1:num_steps

if FT(i)>70

CPayoff(i) = 0;

else

CPayoff(i)= max (FT(i)-K, 0);

end

end

Qprob = binopdf( (num_steps: -1:0)', num_steps, p);

Cprice =exp(-r*t) * (CPayoff*Qprob)

/0&& 1#23' 4 D<.7:69

"#$%&'( ;

2a. We uiscount the expecteu option payout at the iisk fiee iate because we aie

using the iisk-neutial piobability of each option payout insteau of its tiue

piobability. If we weie to ueteimine the tiue piobability of each stock piice, anu

hence each option payout, on a binomial tiee, we woulu then uiscount by an

appiopiiate uiscount iate ieflecting the fact that an option is a leveiageu investment

in the stock. It can be shown mathematically that both these methous piouuce the

same valuation foi the option, so the moie simple, iisk-neutial methou is typically

useu.

2b. A uiffeience between the boiiowing anu lenuing iate woulu leau to a no-

aibitiage banu, insteau of a singulai piice at which the call piice coulu not be

aibitiageu. Any piice within this banu is a feasible piice foi the call.

To calculate this banu, we use the binomial options piicing mouel, fiist setting the

iisk fiee iate equal to the boiiowing iate, 9%:

! !

!" !!

!"!!!!"#! !!!"#!!

! !!!

!

!

! !

!!!"

!!!"#! ! ! !!!"#! ! !"

!!!"#! !!!"#!

! !!"!!"#$

Bence the piice of the call cannot be moie than ! !

!

!

! !" !!"!!"#$ ! !"!!"#$, oi

a maiket paiticipant woulu go shoit the call anu offset it by boiiowing money anu

longing the stock to lock in an aibitiage piofit.

Next, we apply the binomial piicing mouel, setting the iisk fiee iate equal to the

lenuing iate.

!

!

! !

!!!"

!!!"#! ! ! !!!"#! ! !"

!!!"#! !!!"#!

! !!"!!"#$

Likewise, the piice foi the call cannot be less than ! !

!

!

! !" !!"!!"#$ ! !"!!"#$

oi a maiket paiticipant woulu go long the call anu heuge the position by shoiting

the stock anu lenuing money.

So a ieasonable banu foi the call piice is !"!!"#$ !" !"!!"#$

2c. If we assume the investoi has othei taxable income, losses aie tax ueuuctible anu

hence actually have a tax auvantage. Thus the economics payout in the uown state

foi the stock anu call aie:

!"#$% !" !"## ! !

!

!!

!

!

!

!!

!"#$% !" !"#$% ! !

!

!!

!

!

!

!!

Thus we can cieate a system of two equations:

! !

!

!!

!

!

!

!! !!!

!"

! !!

!"

!! !

!

! !

!

!!

!

!

!

!!

! !

!

!!

!

!

!

!! !!!

!"

! !!

!"

!! !

!

! !

!

!!

!

!

!

!!

Solving both foi C anu setting them equal to each othei we get:

! !

!

! !

!

!

!

! ! ! !!

!"

! !!

!"

! ! !

!

! !

!

! !

!

!

!

!

!

!

! !

!

! !

!

!

!

! ! ! !!

!"

! !!

!"

! ! !

!

! !

!

! !

!

!

!

!

!

Cancelling teims we get:

! !

!

!!

!

!

!

!! !!

!

!!

!

!

!

! ! !

!

!!

!

!

!

!! !!

!

!!

!

!

!

Solving foi uelta we get:

! !

!

!

! !!

!

!!

!

! !!

!

!

!

! !!

!

!!

!

! !!

!

!

!!

!

!!

!

! ! !!

!

!!! !!! ! !!

!

By no aibitiage, we know if the payouts foi the stock anu bonu position aie the same as foi

the call, the piice to entei the position must be the same as the piice of the call:

!! !! ! !

Thus we can solve foi B by plugging oui uelta anu the equation above back into one of oui

oiiginal equations:

! !

!

!!

!

!

!

!! !!!

!"

! !!

!"

!! !

!

! !

!

!!

!

!

!

!!! !!

!!

!"

!!!

!"

!

!

!!"

!

!!!

!

! !

!

!!

!

!

!

!!!!!

!

!!" !!"!

!

!!!

!

!

! !

!"

! !!

!

!!

!

!!

!

! !

!

! !!

!

!!!!!

!

!!

!

!! ! !!

!

!

Simplifying this expiession gives:

! !

!

!

!"

!

! !!

!

! !!

!

!

!

!

!!

!

! !!

!

! !

!!

!

!!!

!

! !!

!

!! ! !

!

!!

!

! !!

!

! !!

!

!

The iisk neutial piobability is calculateu by using the noimal foimula but inseiting the tax

aujusteu iisk fiee iate: ! !

!

!"

!

!!!

!

!!!

!

!

!

!

!!

!

!!!

!

!!

!!!

When the thiee tax iates aie set equal to each othei, they cancel fiom the above equations

anu hence uo not affect the piicing of assets. As many laige maiket playeis have all souices

of income taxeu at the same iate, in piactice these assets can be piiceu without consiueiing

the tax iate.

"#$%&'( <

Sa. Asian options aie less expensive than Euiopean options because the volatility of the

aveiage piice of a secuiity is less than the volatility of its spot piice anu the piice of an

option incieases with volatility.

Sb. The question is somewhat ambivalent in uefining the stiike piice. I inteipiet the

question to mean that the stiike piice is equal to the cuiient stock piice, not the aveiage

stock piice, !

!!!!!!

, hence K = Su.SuS.

The option takes the aveiage stock piices ovei the last S months, but because we aie only

constiucting a 1S-step mouel, this time fiame cannot be exactly captuieu. I choose to take

the aveiage ovei the last 8 noues to best captuie the stock piice in the last S months befoie

expiiation.

%define variables

S=50; r= .05; dy = .03; t=1/2; num_steps=15;

dt=t/num_steps;

sigma=.25; K =S*exp((r-dy)*t);

%calculate state coefficients and probabilities

u = (exp( (r-dy)*dt + sigma*sqrt(dt)));

d = (exp( (r-dy)*dt - sigma*sqrt(dt)));

p = (exp((r - dy)*dt) - d)/(u-d);

%create a matrix of 1s and 0s with a row corresponding to

each distinct

%path the stock can take

b =1;

while length(b) ~= 2^num_steps

x = binornd(1, .5, 1000000, num_steps);

b = unique(x, 'rows');

end

%set the 1s in the matrix to u and the 0s to d

b = u.*b;

for n = 1:2^num_steps;

for i = 1:num_steps;

if b(n,i)==0;

b(n,i)=d;

else b(n,i);

end

end

end

%multiply by the prepaid forward price to create a matrix

of each dinstinct

%path the stock can take. If the stock hits 70, set it

equal to zero for the

%remainder of the path.

for n = 1:2^num_steps;

b(n,1)=S*b(n,1);

for i = 2:num_steps;

b(n,i)=b(n,i)*b(n,i-1);

end

end

%find the sum of the last 8 nodes in each distinct path and

create a vector

%of these sums

SC = zeros(2^num_steps,1);

for n = 1:2^num_steps;

for i=8:num_steps;

SC(n) = SC(n)+b(n,i);

end

end

%find the average stock price over the last 8 nodes for

each distinct path

%from these sums

SA=SC/8;

%calculate the payoff of the option for each distinct path

for n = 1:2^num_steps;

Cpayoff(n) = max(SA(n) - K, 0);

end

%find the price of the call by summing the potential

payouts and dividing

%them by the probability of any given distinct stock path

Cprice = exp(-r*t) * sum(Cpayoff)*(1/(2^num_steps))

Call piice = $S.14u2

Sc. It is significantly haiuei to value because it is path uepenuent.

Below is NATLAB coue foi valuing this option assuming it has the same chaiacteiistics as

the options in pioblem 1u. The piice of the call comes to $4.uSuu

%define variables

S=52; K=50; r=.05; d=1.30; exdiv =3/12; t=1/2;

num_steps=15;

dt=t/num_steps;sigma=.25;

%Value of prepaid forward

F = S - d^(-r*exdiv);

%volatility of prepaid forward

sigmaF = sigma * (S/F);

%calculate u and d coefficients and probability of up-state

u = exp( (r*dt + sigmaF*sqrt(dt)));

d = exp( (r*dt - sigmaF*sqrt(dt)));

p = (exp((r*dt)) - d)/(u-d);

%create a matrix of 1s and 0s with a row corresponding to

each distinct

%path the stock can take

b =1;

while length(b) ~= 2^num_steps

x = binornd(1, .5, 1000000, num_steps);

b = unique(x, 'rows');

end

%set the 1s in the matrix to u and the 0s to d

b = u.*b;

for n = 1:2^num_steps;

for i = 1:num_steps;

if b(n,i)==0;

b(n,i)=d;

else b(n,i);

end

end

end

%multiply by the prepaid forward price to create a matrix

of each dinstinct

%path the stock can take. If the stock hits 70, set it

equal to zero for the

%remainder of the path.

for n = 1:2^num_steps;

b(n,1)=F*b(n,1);

for i = 2:num_steps;

if b(n,i-1)>70

b(n,i)=0;

else

b(n,i)=b(n,i)*b(n,i-1);

end

end

end

%calculate the payoff of the option. Since we set the stock

to 0 for all

%paths which resulted in the stock going above 70, we can

ignore this

%feature of the call

for n = 1:2^num_steps;

Cpayoff(n) = max(b(n,num_steps) - K, 0);

end

%find the price of the call by summing the potential

payouts and dividing

%them by the probability of any given distinct stock path

Cprice = exp(-r*t) * sum(Cpayoff)*(1/(2^num_steps))

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