You are on page 1of 9

# Zach Saviuge

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))