Financial strategies and discrete time models

Author: Theodor Munteanu (15 oct 2020)

Problem 1.

Suppose the current price per share of AMAZON is 𝑆0 = 3322$.

The interest rates are 0% and the up and down factors at each step are estimated at 𝑢 = 1.015 and 𝑑 =
0.995.

a. Find the probability that a bull call spread with strikes 𝐾1 = 3250, 𝐾2 = 3390 will be a
profitable one, if the lifetimes of the composing options is 1 year. We assume that the share
price follows a binomial model (in our case will result 4 periods).
b. What is the probability that a butterfly spread would yield a negative profit, if the option
expiries are 6 months each. The strike prices are 𝐾1 = 3300, 𝐾2 = 3325, 𝐾3 = 3350$.

Problem 2: (Probability of exercising a butterfly strategy, when options are European/American)

What is the probability of a butterfly strategy of 3 calls on stock ABC with price 𝑆0 = 120 euros being
exercised, if the strike prices are 𝐾1 = 110, 𝐾2 = 125, 𝐾3 = 130 and option’s lifetime is 𝑇 = 6 𝑚𝑜𝑛𝑡ℎ𝑠
if we assume that the model of the price per share that follows is binomial with 2 periods in the
following cases:

a. All options are European

b. The options with 𝐾1 = 110, 𝐾3 = 130 are American but the second option is European?
c. All options are American?

We assume that the annualized volatility is 𝜎 = 20%.

Problem 3: (Binomial model for European option value when dividend is announced)

Suppose a stock has the value 𝑆0 = 100$ and a European call option is written for a lifetime of 9 months
and having strike 𝐾 = 110$. The underlying implied annual volatility is 𝜎 = 30% (without considering
dividends). A dividend is announced in 4 months, equal to 3$ which is given once a year. The annual
interest rates are assumed to be all 2% (flat term structure of benchmark risk-free rates, continuous
compounding).

a. What is the call option price if we use binomial model?

b. How does the dividend affect the call option value?
Solutions:

Problem 1:

a. The bull call spread is profitable if its payoff is greater than the initial cost.

We must therefore find the price of the bull call spread (long position on lower strike call option, short
position on the higher strike call option).
𝑒 𝑟Δ𝑡 −𝑑 1−0.995
The risk neutral probability is 𝑝 = 𝑢−𝑑
= 1.015−0.095 = 0.25

3525 3456 3388 3321 3256

𝑆𝑇 : ( )
0.3% 4.68% 21.09% 42.18% 31.64%
𝑐(𝑆0 , 𝑢, 𝑑, 𝑇 = 1 𝑦𝑟𝑠, 𝑁 = 4, 𝐾1 = 3250, 𝑟 = 0%) = 72

𝑐 (𝑆0 , 𝑢, 𝑑, 𝑇 = 1 𝑦𝑟𝑠 , 𝑁 = 4, 𝐾1 = 3390, 𝑟 = 0%) = 3.642 so the cost is 𝐼𝐶0 = 72 − 3.642 = 68.358
0, 𝑆𝑇 < 3250
So the payoff which is: 𝜙(𝑆𝑇 ) = {𝑆𝑇 − 3250, 𝑆𝑇 ∈ (3250,3390) has to be higher than 68.358 so the
140, 𝑆𝑇 > 3390
probability required is 𝑃(𝑆𝑇 > 3318.358) = 𝑃(𝑆𝑇 ∈ (𝑆0 𝑢4 , 𝑆0 𝑢3 𝑑, 𝑆0 𝑢2 𝑑2 , 𝑆0 𝑢𝑑3 )) = 1 −
𝑃 (𝑆𝑇 = 𝑆0 𝑑4 ) = 1 − 0.3164

b. The initial cost of the butterfly is 𝑐(𝐾1 = 3300; 𝑇 = 0.5 𝑦𝑟𝑠) − 2𝑐 (𝐾2 = 3325; 𝑇 = 0.5 𝑦𝑟𝑠) +
𝑐 (𝐾3 = 3350; 𝑇 = 0.5 𝑦𝑟𝑠) = 0
0, 𝑆𝑇 < 3300
𝑆𝑇 − 3300, 𝑆𝑇 ∈ (3300,3325)
𝜙(𝑆𝑇 ) = { ≥ 0 ⇔ 𝑆𝑇 ∈ 𝑅+
3350 − 𝑆𝑇 , 𝑆𝑇 ∈ (3300,3325)
0, 𝑆𝑇 > 3350
The required probability is therefore 100% = 1.

Problem 2:

At least one option should be exercised in order for the strategy to be activate so we seek 𝑃 (𝑆𝑇 > 110)
1 1
𝜎√ −𝜎√
The up and down factor are: 𝑢 = 𝑒 4
= 1.1051, 𝑑 = 𝑒 4
= 0.9048

The risk-neutral probability is 𝑝 = 0.4705

a. If all options are European, we need 𝑃 (𝑆2 > 110).

𝑆 𝑢2 = 146.56 𝑆0 𝑢𝑑 = 120 𝑆0 𝑑2 = 98.2476
But 𝑆2 : ( 0 )
𝑝2 2𝑝(1 − 𝑝) (1 − 𝑝)2
The desired result is 𝑃 (𝑆𝑇 > 110) = 𝑝2 + 2𝑝(1 − 𝑝) = 72.43%
b. Because we have no dividends, and the options are calls, it is not optimal to exercise early these
options. Therefore the result is identical with b.
Problem 3:

There are two methods of finding the price.

Method 1: Using the annualized continuous yield

3
The annual dividend yield is 𝑦𝑎𝑛𝑛 = 100 = 0.03. If we convert this to continuous yield we have that 1 +
𝑦𝑎𝑛𝑛 = 𝑒 𝑦𝑐𝑜𝑛𝑡 ⇒ 𝑦𝑐𝑜𝑛𝑡 = log(1 + 𝑦𝑎𝑛𝑛 ) = log (1.03)
𝑆0
We use the adjusted volatility: 𝜎𝑎𝑑𝑗 = 𝜎 ⋅ 𝑆 −𝑟𝑡𝐷 = 30.89%
0 −𝐷𝑒

Now, the up-factor would be, 𝑢 = 𝑒 𝜎𝑎𝑑𝑗 √Δ𝑡 = 1.1672 and 𝑑 = 0.8567 and the risk-neutral probability
𝑒 (𝑟−𝑞)Δ𝑡 −𝑑
of the stock going up is 𝑝 = 𝑢−𝑑
=47.92%

The possible values in 3 periods are: 𝑆0 𝑢3 , 𝑆0 𝑢, 𝑆0 𝑑, 𝑆0 𝑑3 = 159.01,116.72,85.67,62.88.

Out of these, only the first two values give favorable option exercise action and the probabilities of
being exercised are 𝑝 3 and 𝐶31 𝑝2 (1 − 𝑝) =0.11 and 0.3587 respectively.

So the option value is 𝐸 (max(𝑆𝑇 − 𝐾, 0)) = (𝑆0 𝑢3 − 𝐾)+ ⋅ 𝑝3 + (𝑆0 𝑢 − 𝐾)+ ⋅ 3𝑝2 (1 − 𝑝) +
(𝑆0 𝑑 − 𝐾, 0)+ ⋅ 𝑝(1 − 𝑝)2 + (𝑆0 𝑑3 − 𝐾)+ = 49.01 ⋅ 𝑝3 + 6.72 ⋅ 3𝑝2 (1 − 𝑝) = 5.36 where 𝑥 + =
max (𝑥, 0)
Method 2: Using adjusted stock value on the binomial tree
𝒂𝒅𝒋
𝑺𝟎 = 𝑆0 − 𝐷𝑒 −𝑟𝑡𝐷 =97.0199

𝜎𝑎𝑑𝑗 = 30.92%
0.3092
𝑢 = 𝑒 𝜎𝑎𝑑𝑗 √Δ𝑡 = 𝑒 2 = 1.1671, 𝑑 = 0.8567
𝑒 𝑟Δ𝑡 −𝑑
𝑝= 𝑢−𝑑
= 0.4775

We apply now the final step from method 1 by replacing 𝑆0 with 𝑆0𝑎𝑑𝑗 .

We obtain the result 5.89.

REMARK: We obtain different results because in the first method, the dividend adjustment does not
take into account the timing, while the second method uses the timing.

REMARK2: The larger the dividend, the cheaper should be the call option, because the expected value
of the underlying asset price will be lower, hence its probability of surpassing the level 𝑲.