Tutorial solutions week 10

Question 1.
a) Explain what we mean when we say that the binominal model is a discrete time model and the
Black – Scholes model is a continuous time model.
b) What is the most critical variable in the Black – Scholes model? Explain.

Answer
a) In a discrete time model, the stock price can make a jump to only one of two possible values.
The length of time over which the move can be made is finite.

In a continuous time model, the stock price can jump to an infinite number of possibilities. The
length of time over which the move can be made is infinitesimal (very, very small).

The difference between the two models is perhaps best described the difference between still
photos and a movie.

b) The volatility is the most critical variable for two reasons: (1) it is the only variable that is not
directly observable and, thus, it must be estimated, and (2) the model is particularly sensitive to
the estimate of volatility.

Question 2.
What are assumptions behind Black-Scholes-Merton model?

Answer
▪ Stock price is lognormal distributed and stock return is normal distributed
▪ Short selling allowed
▪ No dividends on the stock
▪ No arbitrage opportunities
▪ Continuous security trading
▪ No transactions costs or taxes. All securities are divisible
▪ The risk-free rate of interest, r, is constant and the same for all maturities
Question 3.
What is the price of a European call option on a non‐dividend‐paying stock when the stock price
is $52, the strike price is $50, the risk‐free interest rate is 12% pa, the volatility is 30% pa, and
the time to maturity is 3 months?

Answer
𝑆0 = 52, K=50, r=0.12, T=0.25, 𝜎 = 0.3

52 0.32
ln ( ) + (0.12 + 2 ) 0.25
50
𝑑1 = = 0.5365
0.3√0.25

𝑑2 = 𝑑1 − 0.3√0.25 = 0.3865

N(𝑑1 )=N(0.5365)= N(0.53)+0.65*[N(0.54)-N(0.53)]=0.7019+0.65*[0.7054-0.7019]=0.7042

N(𝑑2 )=N(0.3865)= N(0.38)+0.65*[N(0.39)-N(0.38)]=0.6480+0.65*[0.6517-0.6480]=0.6504

c = 52*0.7042 – 50e-0.12x0.25*0.6504=5.06

Question 4.
Using Black-Scholes-Merton model, compute the price of a 3 month European put on the same
stock in question 3, with strike price of $50.

Answer

N(−𝑑1 )=1- N(𝑑1 )= 1-0.7042=0.2958

N(−𝑑2 )=1- N(𝑑2 )= 1-0.6504=0.3496

p = 50e-0.12x0.25*0.3496- 52*0.2958 = 1.58

Question 5.
Redo question 4 without using the Black‐Scholes-Merton model.

Answer
Using put-call parity
c+Ke-rT=p+𝑆0

 p= c+Ke-rT-𝑆0 =5.06+50e-0.12x0.25-52=1.58
Question 6.
Calculate the price of a six-month European put option on a non-dividend-paying stock with a
strike price of $70 when the current stock price is $69, the risk-free interest rate is 5% per
annum, and the volatility is 35% per annum.

Answer
S0  69 , K  70 , r  005 ,   035 and T  05 .
ln(69  70)  (005  0352  2)  05
d1   01666
035 05
d 2  d1  035 05  00809
N(−𝑑1 )=N(-0.1666)= N(-0.16)-0.66*[N(0.16)-N(0.17)]= 0.4364-0.66*[0.4364- 0.4325]=0.4338

N(−𝑑2 )=N(0.0809)= N(0.08)+0.09*[N(0.09)-N(0.08)]= 0.5319+0.09*[0.5359-0.5319]=0.5323

The price of the European put is

70e00505 N (00809)  69 N (01666)
 70e0025  05323  69  04338
 640

Question 7.
Show that the Black–Scholes–Merton formulas for call and put options satisfy put–call parity.

Answer
The Black–Scholes–Merton formula for a European call option is
c  S0 N (d1 )  Ke rT N (d2 )
so that
c  Ke rT  S0 N (d1 )  Ke rT N (d2 )  Ke rT
or
c  Ke rT  S0 N (d1 )  Ke rT [1  N (d 2 )]
or
c  Ke rT  S0 N (d1 )  Ke rT N (d2 )

The Black–Scholes–Merton formula for a European put option is

p  Ke rT N (d2 )  S0 N (d1 )
so that
p  S0  Ke rT N (d2 )  S0 N (d1 )  S0
or
p  S0  Ke rT N (d2 )  S0 [1  N (d1 )]
or
p  S0  Ke rT N (d2 )  S0 N (d1 )
This shows that the put–call parity result c  Ke rT  p  S0 holds.