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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 )

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


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.

Copyright Natalia A. Humphreys, 2014

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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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 2.

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
Thus, the call premium is:
p =

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


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
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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 2.

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
Then the put premium is:
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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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 2.

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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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 2.

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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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 2.

(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
Determine the option premium.
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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