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# ACTS 4302

## Instructor: Natalia A. Humphreys

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 )

## The lowest possible price for this call option is:

P
F0,T
(S) KerT = SeT KerT =

## = 33e0.045 31e0.055 = 31.5479 29.3410 = 2.2069 2.21

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

## Here, K1 = 49, K2 = 45, K3 = 42. Hence, K2 K3 = 3, K1 K2 = 4, K1 K3 = 7 and

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.

## ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 2.

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
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## The put tree:

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
p =

## C = erh (p Cu + (1 p )Cd ) = e0.0451 (0.6726 5 + 0.3274 0) = 3.2150 3.22

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
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## Calculating u and d, we obtain:

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


## (b) Using the formula for risk-neutral probability:

e(r)h d
e0.03751 0.84
=
= 0.6194, 1 p = 0.3806
ud
0.32
p =

## P = erh (p Pu + (1 p )Pd ) = e0.03751 (0.6194 0 + 0.3806 13) = 4.7655 same as in (a).

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
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## Calculating u and d, we obtain:

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


## For the put we have:


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


## (b) By the PCP:

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
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## Let us find the replicating portfolio for this option:



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 =

## P = erh (p Pu + (1 p )Pd ) = e0.04h (1 p )6.5

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:
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## (i) The tree has 1 period.

(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
Solution. Calculate u, d and p :

## u = e(r)h+ h = e(0.0450.03)1+0.2 1 = 1.2399

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

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