Derivatives Problems

Meaning of variables:

S = current stock price.

K = strike price of the option.

C = call option price.

P = put option price.

σ = annual stock price volatility.

r = annual continuously compounded risk-free interest rate.

T = time to expiration.

∂ = annual continuously compounded dividend yield.

A note on the function N(x): N(x) is called the cumulative normal distribution function. It is the
probability that a randomly chosen number in the standard normal distribution (where mean = 0
and variance = 1) is less than x. It is impossible to directly integrate the normal probability
distribution function to find N(x). On the exam, you will be given a table of values for N(x), so
such integration will not be necessary. Here, however, we will use the Microsoft Excel function
NormSDist. Try entering “=NormSDist(1)” into a cell in MS Excel. The result should be
0.84134474. Using this method will give us greater accuracy than using a table would.

We also note that N(-x) = 1 – N(x), since the probability of being below -x within the standard
normal distribution is the same as the probability of being above x within the standard normal
distribution.

We will proceed gently with applying the formula, its components, and its variants for different
underlying assets. There will be plenty of uses for this formula throughout future sections of this
study guide.

Source: McDonald, R.L., Derivatives Markets (Second Edition), Addison Wesley, 2006, Ch. 12,
pp. 375-379.
Original Practice Problems and Solutions from the Actuary’s Free Study Guide:

Problem BSF1. The stock of Blackscholesian Co. currently sells for $1500 per share. The
annual stock price volatility is 0.2, and the annual continuously compounded risk-free interest
rate is 0.05. The stock’s annual continuously compounded dividend yield is 0.03. Find the value
of d1 in the Black-Scholes formula for the price of a call option on Blackscholesian Co. stock
with strike price $1600 and time to expiration of 3 years.

Solution BSF1. We use the formula d1 = [ln(S/K) + (r – ∂ + 0.5σ2)T]/[σ√(T)], where we are

given that S = 1500, K = 1600, r = 0.05, ∂ = 0.03, σ = 0.2, and T = 3.

Thus, d1 = [ln(1500/1600) + (0.05 – 0.03 + 0.5*0.22)3]/[0.2√(3)] = d1 = 0.1601034988

Problem BSF2. The stock of Blackscholesian Co. currently sells for $1500 per share. The
annual stock price volatility is 0.2, and the annual continuously compounded risk-free interest
rate is 0.05. The stock’s annual continuously compounded dividend yield is 0.03. Find the value
of d2 in the Black-Scholes formula for the price of a call option on Blackscholesian Co. stock
with strike price $1600 and time to expiration of 3 years.

Solution BSF2. We use the formula d2 = d1 – σ√(T), where, from Solution BSF1, d1 =
0.1601034988 and we are given that T = 3 and σ = 0.2. Thus, d2 = 0.1601034988 – 0.2√(3) =

d2 = -0.1863066628

Problem BSF3. The stock of Blackscholesian Co. currently sells for $1500 per share. The
annual stock price volatility is 0.2, and the annual continuously compounded risk-free interest
rate is 0.05. The stock’s annual continuously compounded dividend yield is 0.03. Use the Black-
Scholes formula to find the price of a call option on Blackscholesian Co. stock with strike price
$1600 and time to expiration of 3 years.

Solution BSF3. We use the formula C(S, K, σ, r, T, ∂) = Se-∂TN(d1) – Ke-rTN(d2), where we

know that S = 1500, K = 1600, r = 0.05, ∂ = 0.03, σ = 0.2, and T = 3. From Solution BSF1, d1 =
0.1601034988. From Solution BSF2, d2 = -0.1863066628.

We find N(d1) via MS Excel using the input “=NormSDist(0.1601034988)” = N(d1) =

0.563600238.

We find N(d2) via MS Excel using the input “=NormSDist(-0.1863066628)” = N(d2) =

0.426102153
Thus, C(S, K, σ, r, T, ∂) = 1500e-0.03*30.563600238 – 1600e-0.05*30.426102153 =

C(S, K, σ, r, T, ∂) = $185.8385153

Problem BSF4. The stock of Blackscholesian Co. currently sells for $1500 per share. The
annual stock price volatility is 0.2, and the annual continuously compounded risk-free interest
rate is 0.05. The stock’s annual continuously compounded dividend yield is 0.03. Find the price
of a put option on Blackscholesian Co. stock with strike price $1600 and time to expiration of 3
years.

Solution BSF4. We recall that, since the call price is known from Solution BSF3, we can use
put-call parity to get the put price: P(S, K, σ, r, T, ∂) = C(S, K, σ, r, T, ∂) + Ke-rT – Se-∂T

where C(S, K, σ, r, T, ∂) = 185.8385153, S = 1500, K = 1600, r = 0.05, ∂ = 0.03, and T = 3.

Thus, P(S, K, σ, r, T, ∂) = 185.8385153 + 1600e-0.05*3 – 1500e-0.03*3 =

P(S, K, σ, r, T, ∂) = $192.0744997

Problem BSF5. The stock of Blackscholesian Co. currently sells for $1500 per share. The
annual stock price volatility is 0.2, and the annual continuously compounded risk-free interest
rate is 0.05. The stock’s annual continuously compounded dividend yield is 0.03. Within the
Black-Scholes formula for the price of a put option on Blackscholesian Co. stock with strike
price $1600 and time to expiration of 3 years, find the value of N(-d2).

Solution BSF5. We use the formula N(-x) = 1 – N(x). We know from Solution BSF3 that N(d2)
= 0.426102153. Thus, N(-d2) = 1 – N(d2) = 1 – 0.426102153 = N(-d2) = 0.573897847

Problem BSFOSDD1. The stock of Auspicious Co. currently trades for $221 per share. The
stock will pay a dividend of $40 in 2 years and another dividend of $32 in 6 years. The annual
continuously compounded risk-free interest rate is 0.05, and the annual price volatility relevant
for the Black-Scholes equation is 0.3. Call options are written on Auspicious Co. stock with a
strike price of $250 and time to expiration of 8 years. Calculate d1 in the Black-Scholes formula
for the price of one such call option.

Solution BSFOSDD1. First, we convert the asset and strike price terms into prepaid forward
prices. FP0,T(S) = S0 – PV0,T(Div) = 221 – 40e-2*0.05 – 32e-6*0.05 = FP0,T(S) =
161.1003202
FP0,T(K) = Ke-rT = 250e-8*0.05 = 167.5800115. Here, T = 8 and σ = 0.3.

Now we use the formula d1 = [ln(FP0,T(S)/FP0,T(K)) + 0.5σ2T]/[σ√(T)] =

[ln(161.1003202/167.5800115) + 0.5*0.32*8]/[0.3√(8)] = d1 = 0.3777910782

Problem BSFOSDD2. The stock of Auspicious Co. currently trades for $221 per share. The
stock will pay a dividend of $40 in 2 years and another dividend of $32 in 6 years. The annual
continuously compounded risk-free interest rate is 0.05, and the annual price volatility relevant
for the Black-Scholes equation is 0.3. Call options are written on Auspicious Co. stock with a
strike price of $250 and time to expiration of 8 years. Calculate d2 in the Black-Scholes formula
for the price of one such call option.

Solution BSFOSDD2. We use the formula d2 = d1 – σ√(T), where T = 8, σ = 0.3, and

d1 = 0.3777910782 from Solution BSFOSDD1. So d2 = d1 – σ√(T) = 0.3777910782 – 0.3√(8) =

d2 = -0.4707370592

Problem BSFOSDD3. The stock of Auspicious Co. currently trades for $221 per share. The
stock will pay a dividend of $40 in 2 years and another dividend of $32 in 6 years. The annual
continuously compounded risk-free interest rate is 0.05, and the annual price volatility relevant
for the Black-Scholes equation is 0.3. Call options are written on Auspicious Co. stock with a
strike price of $250 and time to expiration of 8 years. Use the Black-Scholes formula to find the
price of one such call option.

Solution BSFOSDD3. We use the formula

C(FP0,T(S), FP0,T(K), σ, T) = FP0,T(S)N(d1) – FP0,T(K)N(d2). We know from Solutions

BSFOSDD1-2 that d1 = 0.3777910782, d2 = -0.4707370592, FP0,T(S) = 161.1003202,

FP0,T(K) = 167.5800115.

In MS Excel, using the input “=NormSDist(0.3777910782)”, we find that N(d1) = 0.647207046

In MS Excel, using the input “=NormSDist(-0.4707370592)”, we find that N(d2) = 0.318914268

Thus, C(FP0,T(S), FP0,T(K), σ, T) = 161.1003202*0.647207046 – 167.5800115*0.318914268 =

C(FP0,T(S), FP0,T(K), σ, T) = $50.82160565

Problem BSFOSDD4. The stock of Auspicious Co. currently trades for $221 per share. The
stock will pay a dividend of $40 in 2 years and another dividend of $32 in 6 years. The annual
continuously compounded risk-free interest rate is 0.05, and the annual price volatility relevant
for the Black-Scholes equation is 0.3. Put options are written on Auspicious Co. stock with a
strike price of $250 and time to expiration of 8 years. Use the Black-Scholes formula to find the
price of one such put option.

Solution BSFOSDD4. Since the corresponding call option price is known (from Solution
BSFOSDD3), we can use put-call parity to find the put option price.

P(FP0,T(S), FP0,T(K), σ, T) = C(FP0,T(S), FP0,T(K), σ, T) + FP0,T(K) – FP0,T(S) =

50.82160565 + 167.5800115 – 161.1003202 = P(FP0,T(S), FP0,T(K), σ, T) = $57.30129695

Problem BSFOSDD5. You are given that d1 in the Black-Scholes formula for the price of a
particular call option on Unstoppable Co. is 0.4. You also know that the current stock price of
Unstoppable Co. is $56, the relevant annual price volatility is 0.03, the price of the prepaid
forward on the strike asset is $42, and the option’s time to expiration is 2 years. The annual
continuously-compounded interest rate is 0.03. The stock of Unstoppable Co. will pay one
discrete dividend in 1 year. Find the size of the dividend.

Solution BSFOSDD5. We use the formula d1 = [ln(FP0,T(S)/FP0,T(K)) + 0.5σ2T]/[σ√(T)],

which we rearrange as follows: d1σ√(T) = [ln(FP0,T(S)/FP0,T(K)) + 0.5σ2T]

d1σ√(T) – 0.5σ2T = ln(FP0,T(S)/FP0,T(K))

exp(d1σ√(T) – 0.5σ2T) = FP0,T(S)/FP0,T(K)

FP0,T(K)exp(d1σ√(T) – 0.5σ2T) = FP0,T(S)

We are given that FP0,T(K) = 42, d1 = 0.4, σ = 0.03, T = 2. Thus,

FP0,T(K)exp(d1σ√(T) – 0.5σ2T) = 42exp(0.4*0.03√(2) – 0.5*0.032*2) = FP0,T(S) =

42.68041633

Now we use the formula FP0,T(S) = S0 – PV0,T(Div) and rearrange it thus:

PV0,T(Div) = S0 – FP0,T(S) = 56 – 42.68041633 = 13.31958367
PV0,T(Div) = Div*e-1*0.03 = 13.31958367

So Div = 13.31958367e0.03 = Div = 13.72522538

Problem CPTOP1. The annualized standard deviation of the continuously compounded stock

return for Malicious Co. is currently 0.90. The annual continuously compounded interest rate is
0.07, and Malicious Co. pays dividends on its stock at an annual continuously compounded yield
of 0.05. Using the one-period binomial option pricing model, what is the factor by which the
price of Malicious Co. might increase in 3 years?

Solution CPTOP1. We use the formula u = e(r-∂)h + σ√(h), and we are given that h = 3, σ = 0.9,
r = 0.07, ∂ = 0.05 (so r – ∂ = 0.02). Thus, u = e0.02*3 + 0.9√(3) = e1.618845727 =

u = 5.047261035

Problem CPTOP2. The annualized standard deviation of the continuously compounded stock

return for Malicious Co. is currently 0.90. The annual continuously compounded interest rate is
0.07, and Malicious Co. pays dividends on its stock at an annual continuously compounded yield
of 0.05. Using the one-period binomial option pricing model, what is the factor by which the
lower possible price of Malicious Co. might be multiplied in 5 years? (That is, find the possible
ratio of Malicious Co.’s lower price in 5 years to its price today.)

Solution CPTOP2. We use the formula d = e(r-∂)h – σ√(h), and we are given that h = 5, σ = 0.9,
r = 0.07, ∂ = 0.05 (so r – ∂ = 0.02). Thus, d = e0.02*5 – 0.9√(5) = e-1.91246118 = d =

d = 0.1477163823

Problem CPTOP3. The 10-year forward contract on Auspicious, Inc., stock is currently worth
$567. The annualized standard deviation of the continuously compounded stock return for
Auspicious, Inc., is currently 0.02. If the price of Auspicious, Inc., increases after 10 years, what
will it be using the one-period binomial option pricing model?

Solution CPTOP3. We use the formula uSt = Ft, t+heσ√(h), and we are given that h = 5, σ =
0.02, Ft, t+h = 567. Thus, uSt = 567*e0.02√(5) = uSt = $592.9325586.

Problem CPTOP4. You think that the price of Suspicious LLC stock will decline in 1 month.
Currently, a 1-month forward contract on Suspicious LLC stock sells for $423. The annualized
standard deviation of the continuously compounded stock return for Suspicious LLC stock is
currently 0.56. Using the one-period binomial option pricing model, what might the lower price
of Suspicious LLC stock be in 1 month?
Solution CPTOP4. We use the formula dSt = Ft, t+he-σ√(h), and we are given that h = 1/12, σ =
0.56, Ft, t+h = 423. Thus, dSt = 423*e-0.56√(1/12) = dSt = $359.8596534

Problem CPTOP5. Vicious Co. stock may increase or decline in 1 year under the assumptions
of the one-period binomial option pricing model. Vicious Co. pays no dividends on its stock, and
the annualized standard deviation of the continuously compounded stock return for Vicious Co.
stock is 0.81. A 1-year forward contract on Vicious Co. stock currently sells for $100. Vicious
Co. stock currently sells for $90. What is the annual continuously compounded risk-free interest
rate?

Solution CPTOP5. We first use the formula dSt = Ft, t+he-σ√(h), knowing that σ = 0.81, h = 1,
Ft, t+h = 100, St = 90. Thus, d = Ft, t+he-σ√(h)/St = (100/90)e-0.81 = 0.4942867402

Furthermore, we apply the formula d = e(r-∂)h – σ√(h). Thus, because the stock pays no
dividends, 0.4942867402 = er-0.81. Thus, r = ln(0.4942867402) + 0.81 = r = 0.1053605157