AS310

STOCHASTIC CALCULUS FOR INSURANCE & FINANCE

Midterm Test
September-December 2021

ANSWER ALL QUESTIONS Time: 1 hour

1. (a) The current price of a non-dividend-paying stock is $50. The price is expected to rise to
$55 or fall to $45. An investor buys one-year put options with a strike price of $48. By assuming
a riskless portfolio setting, find the number of shares required to hedge the position. (20 marks)

(b). A six-month European call option on a non-dividend paying stock has a strike price of $16.
Suppose the current price of the stock is $15, the risk-free interest rate is 8% per annum with
continuous compounding. Use a two-step tree, where each step is 3 months, to value this
European call option with the probability of up movement equal to 0.6010. (35 marks)

2. (a) Explain how American options can be calculated by using a binomial tree. (10 marks)

(b) The current price of a non-dividend paying stock is $25. The risk-free interest rate is 5%
per annum, and the volatility is 20%. Use a two-step binomial tree to value a one-year American
put option on the stock with a strike price of $24. (35 marks)

END OF PAPER

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