INSTITUTE OF BUSINESS MANAGEMENT

2nd Assessment
Course Title: Applied Financial Economics Course Code: ECO 408
Faculty: Steve Ernest Section:-
Day /Date: Sun/16th August 20’Start Time:-

Student’s Name: MAMOON UR RASHEED Student ID: 20191-25346

Note: Please attempt all questions.

1.

2.

3.

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4.

5.

Solution 1
Risk neutral probability = p* = (e^(r-delta)*h – d) / u-d
P* = (50e^ (0.06-d) (0.5) – 40) / 25
For delta = 0,
Call premium = e^-0.5(0.06) (62-62)
Call Premium = 13e^-0.03
P* = (50e^0.03 – 40) / 25
P* = 0.460909

For delta = 0.02

P* = (50e^0.02 – 40) / 25
P* = 0.440403

Change in Premium = 13 e^-0.03(0.440403 – 0.460909) =

Change in Premium = -0.2587

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Solution 2
Range = 60 – 40 = 20

Diff in payoff = 0 – 10

Delta = (-10 / 20) = -0.5

60 (0.5) + e^0.05 B = 0

-30 + e ^0.05 B = 0

B = 30 e^-0.05

B = 28.537=69

Put premium =-0.5(50) +28.5369

Premium = 3.5369

Solution 3
Stock can go up to = u * S = 1.2(50) = 60

Payoff when price rises = 60 -55 = 5

Stock can go down to = d*S = 0.7(50) = 35

Price of call = payoff x p* e^-0.25r = 5 ((e^0.25r – 0.7) / (1.2 – 0.7)) e^-0.25r

3.10 = 10 (1-0.7 e^-0.25r)

0.31 = 1 – 0.7 e^-0.25r

-0.69 = - 0.7 e^-0.25r

- 069/-0.7 = e^-0.25 r

0.69/0.7 = e^-0.25 r

Ln 0.69/0.7 = ln (e^-0.25r)

- 0.01438872295= - 0.25 r

r = -0.014388372295 / - 0.25

r = 0.0575549

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Solution 4

First set the lower and upper nodes.

U = e^(r-δ) + δ = e^0.05-0.02+0.3 = e^0.33

d = e^(r-δ) -δ = e^0.05-0.02-0.3 = e^0.27

0.03 −0.27
e(r−δ )−D e −e
For P* = = 0.33 0.27
U −d e −e

1.030455−0.763379
P* =
1.390968−0.763379

P* = 0.42556

Solution 5

Assume ∆q be the no of shares of Q for replicating portfolio.

And ∆s be the number of shares of S for replicating portfolio.

And suppose B the amount invested in a risk free Bond.

Payoff of the portfolio from top to bottom are 40, 50 and 110.

Then,

90∆s + 30∆q + Be^0.05 = 40

90∆s + 100∆q + Be^0.05 = 50

200∆q + Be^0.05 = 110

Use substitute method:

Subtract the second equation from the 1st,

90∆s + 100∆q + Be^0.05 = 50

-90∆s - 30∆q - Be^0.05 = -40

70∆q= 10________________

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∆q= 1/7

Then find the value of be^0.05 from 3rd equation:

200∆q + Be^0.05 = 110

200
Be^0.05 = 110 -
7

Put both values into 1st equation:

30
40− −81.486
∆s = 7 = -0.5079
90

The option portfolio worth is;

50 (-0.5079) + 100/7 +81.4286e^-0.05 = 66.35