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SOLUTION TO HOMEWORK 2

Lesson 2: Comparing Options

Lesson 3: Binomial Trees - Stock, One Period

Problem 1

You are given:

(i) The price of a stock is 33.

(ii) The stock pays continuous dividends at the annual rate of 0.045.

(iii) The continuously compounded risk-free interest rate is 0.055.

(iv) A one-year American call option on the stock has a strike price of 31.

Determine the lowest possible price for this call option.

Solution. Recall the inequalities for American and European call options:

P

S CAmer (S, K, T ) CEur (S, K, T ) max(0, F0,T

(S) KerT )

P

F0,T

(S) KerT = SeT KerT =

Problem 2

You are given the following prices for American call options:

Strike price Option price

42

11

49

4

Determine the highest possible price for an American call option with strike price 45.

Solution. Using convexity property: For K1 > K2 > K3

C(K2 )

K1 K3

C(K2 )

3 4 + 4 11

56

=

=8

7

7

Problem 3

For a stock, you are given:

(i) The stocks price is 39.

(ii) The stock pays dividends continuously at a rate proportional to its price. The dividend yield is

1.5%.

(iii) A 9-month 37-strike European call option has premium 9.5.

(iv) A 9-month 46-strike European call option has premium 3.

(v) The continuously compounded risk-free interest rate is 4.5%.

Determine the lowest and the highest arbitrage-free premiums for a 9-month 41-strike European put

option on the stock.

Solution. We will determine the max and min values of the 9-month 41-strike European call option

on the stock and then determine the max and min values of the corresponding put option using the

Put Call Parity.

Using convexity property: If K1 > K2 > K3 then

(K2 K3 )C(K1 ) + (K1 K2 )C(K3 )

C(K2 )

K1 K3

Here, K1 = 46, K2 = 41, K3 = 37. Hence, K2 K3 = 4, K1 K2 = 5, K1 K3 = 9 and

4 3 + 5 9.5

C(K2 )

= 6.6111

9

Therefore, max C(40) = 6.6111

On the other hand, since the maximum possible value of the difference between the two calls is

max(C(K3 ) C(K2 )) = erT (K2 K3 )

The minimum C(41) could be determined as:

min C(41) = C(37) 4e0.0450.75 = 9.5 3.8673 = 5.6327

By the PCP for a dividend paying stock with continuous dividends,

C(S, K2 , T ) P (S, K2 , T ) = S0 eT K2 erT

P (S, K2 , T ) = C(S, K2 , T ) S0 eT + K2 erT

P (39, 41, 0.75) = C(39, 41, 0.75) 39e0.0150.75 + 41e0.0450.75 = C(39, 41, 0.75) 38.56379 +

+39.6393 = C(39, 41, 0.75) + 1.0756

Since max C(41) = 6.6111 and min C(41) = 5.63279, by the relation above, max P (41) = 6.6111 +

1.0756 = 7.6866 and min P (41) = 5.6327 + 1.0756 = 6.7082

Problem 4

A 1-year European call and put options on a non-dividend paying stock has a strike price of 80. You

are given:

(i) The stocks price is currently 75.

(ii) The stocks price will be either 85 or 65 at the end of the year.

(iii) The continuously compounded risk-free rate is 4.5%.

(a) Determine the premium for the call.

(b) Determine the premium for the put.

Solution. The stock tree:

uS = 85

S = 75

dS = 65

The call tree:

Cu = 5

C

Cd = 0

Page 2 of 7

Pu = 0

P

Pd = 15

Calculating u and d, we obtain:

85

65

= 1.1333, d =

= 0.8667, u d = 0.2667

75

75

Using the formula for risk-neutral probability:

u=

e0.0451 0.8667

e(r)h d

=

= 0.6726, 1 p = 0.3274

ud

0.2667

Thus, the call premium is:

p =

And the put premium is:

P = erh (p Pu + (1 p )Pd ) = e0.0451 (0.6726 0 + 0.3274 15) = 4.6948 4.70

Problem 5

A 1-year European put option on a non-dividend paying stock has a strike price of 55. You are given:

(i) The stocks price is currently 50.

(ii) The stocks price will be either 58 or 42 at the end of the year.

(iii) The continuously compounded risk-free rate is 3.75%.

The replicating portfolio consists of shares of stock and of lending B.

(a) Determine and B and calculate the put premium.

(b) Verify that the put price calculated in (a) is the same as if calculated using the risk-neutral pricing

method.

Solution. (a) The stock tree:

uS = 58

S = 50

dS = 42

The put tree:

Pu = 0

P

Pd = 13

Page 3 of 7

u=

58

42

= 1.16, d =

= 0.84, u d = 0.32

50

50

Note that

13

Pu Pd

eh =

=

= 0.8125

S(u d)

50 0.32

1.16 13

uPd dPu

= e0.03751

= 45.3905

B = erh

ud

0.32

P = S + B = 50 (0.8125) + 45.3905 = 4.7655

e(r)h d

e0.03751 0.84

=

= 0.6194, 1 p = 0.3806

ud

0.32

Then the put premium is:

p =

Problem 6

A 1-year European put and call options on a stock paying continuous dividend at the rate of 3% has

a strike price of 61. You are given:

(i) The stocks price is currently 57.

(ii) The stocks price will be either 70 or 49 at the end of the year.

(iii) The continuously compounded risk-free rate is 5.6%.

(a) Calculate the replicating portfolios and derive the option premiums from it.

(b) Verify your answers by showing that they satisfy the Put-Call Parity.

Solution. (a) The stock tree:

uS = 70

S = 57

dS = 49

The call tree:

Cu = 9

C

Cd = 0

The put tree:

Pu = 0

P

Pd = 12

Page 4 of 7

70

49

u=

= 1.2281, d =

= 0.8597, u d = 0.3684

57

57

For the call we have:

9

Cu Cd

eh =

=

e0.03 = 0.4159

S(u d)

57 0.3684

0.8597 9

rh uCd dCu

= e0.0561

B=e

= 19.8563

ud

0.3684

C = S + B = 57 0.4159 19.8563 = 3.8503

12

Pu Pd

eh =

=

e0.03 = 0.5545

S(u d)

57 0.3684

1.2281 12

rh uPd dPu

= 37.8216

B=e

= e0.0561

ud

0.3684

P = S + B = 57 (0.5545) + 37.8216 = 6.2128

C P = SeT KerT

C P = 3.8503 6.2128 = 2.3625

SeT KerT = 57e0.03 61e0.056 = 55.3154 57.6779 = 2.3625

Thus, C and P calculated in (a) satisfy the PCP.

Problem 7

A 6-month European call option is modeled with the following 1-period binomial tree:

65

55

40

(i) The strike price is 60.

(ii) The continuously compounded risk-free rate is 5.5%.

Determine the change in the premium for the call option if the continuous dividend rate increases

from 0 to 3%.

Solution. The call tree:

Cu = 5

C

Cd = 0

Note that

u=

65

40

= 1.1818, d =

= 0.7272 u d = 0.4545

55

55

Page 5 of 7

Cu Cd

5

=

eh = e0.5 = 0.2e0.5

S(u d)

25

0.7272 5

rh uCd dCu

= e0.0550.5

= 7.783

B=e

ud

0.4545

C = S + B = 55 0.2e0.5 7.783 = 11e0.5 7.783

C( = 0) C( = 3%) = 11 11e0.50.03 = 0.1638

Note that you could also calculate the call prices directly first and then subtract:

C( = 0) = 3.217, C( = 3%) = 3.0532

Hence,

C( = 0) C( = 3%) = 3.217 3.0532 = 0.1638

Problem 8

A European put option on a stock is modeled with a 1-period binomial tree. You are given:

(i) The stock price is 30.

(ii) The strike price is 32.

(iii) The continuously compounded risk-free rate is 4%.

(iv) The stock pays no dividend.

(v) u = 1.25 and d = 0.85.

(vi) The put premium is 3.25.

Determine the time to expiry for this option.

Solution. The stock tree:

uS = 37.5

S = 30

dS = 25.5

The put tree:

Pu = 0

P

Pd = 6.5

Using the formula for risk neutral probability:

e(r)h d

e0.04h 0.85

=

= 2.5e0.04h 2.125

ud

0.4

On the other hand, using a formula for pricing an option with risk neutral probability:

(1)

p =

3.25 0.04h

(2)

p = 1

e

= 1 0.5e0.04h

6.5

Equating the (1) and (2) above, we obtain:

1

1 0.5e0.04h = 2.5e0.04h 2.125 e0.04h = 1.04167 h =

ln 1.04167 = 1.0206

0.04

Problem 9

For a 1-year European put option on a stock modeled with a binomial tree:

Page 6 of 7

(ii) The tree is constructed based on forward prices.

(iii) The stock price is 41.

(iv) The strike price is 41.

(v) The continuously compounded risk-free rate is 4.5%.

(vi) The stock pays continuous dividends at the rate of 3%.

(vii) = 0.2

Determine the option premium.

Solution. Calculate u, d and p :

d = e(r)h h = e(0.0450.03)10.2 1 = 0.8311

u d = 1.1093 0.9082 = 0.4088

1

1

=

p =

= 0.4502

h

1

+

e0.1

1+e

1 p = 0.5498

The stock tree:

uS = 50.8343

S = 41

dS = 34.0752

The put tree:

Pu = 0

P

Pd = 6.9248

Using a formula for pricing an option with risk neutral probability:

P = erh (p Pu + (1 p )Pd ) = e0.0451 (0.5498 6.9248) = 3.63995

Problem 10

A 1-period binomial tree is constructed for a 6-month option on a stock. You are given:

(i) The initial price of the stock is 42.50.

(ii) The risk-free rate is 6%.

(iii) The stock pays dividends at a continuous rate of 3.5%.

Determine the greatest lower bound for values of the stock at the upper node of the binomial tree.

Solution. The stock must have a possibility of increasing at least by r , or else a risk-free bond

would pay more. To avoid arbitrage, u and d must satisfy:

d < e(r)h < u

Thus,

inf(uS) = e(r)h S = e(0.060.035)0.5 42.50 = 1.0126 42.50 = 43.0346

Page 7 of 7

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