1

ECO347-FAC407
HW 3

Q1. (30 points)

TCS stock has today’s price of Rs. 100. Consider the Indian stock market where after one month there
are only three possible prices of the stock: Rs. 105, Rs. 101, and Rs. 98. A European call on that stock,
with strike Rs. 100 and maturity in one month, has a price of Rs. 2.50. ST has Rs. 100 to invest, and
believes that the most likely outcome is the highest price.
a) If he invests all of his capital, what’s the relative return he’ll get after one month for each price
state?
b) Consider the call to be increasing in the price of the stock, so ST decides to invest all his capital in
the call. How many calls will he be able to purchase?
c) What’ll be the payoff of each call for the different states of the price? In which state the option
will not be exercised? What’ll be left of the investment?
d) What’ll be the relative return for the investor in those states?
e) What’s the lesson from this scenario?

Q2. (40 points)

Prove that time averaging and ensemble averaging of a random variable commute – that is, they’re
independent of the ordering of the averaging processes:
< ( )>=< ( )>

Q3. (30 points)

At time = 0, ST takes a short in futures on 20 shares of TCS stock at the futures price of INR 50.00.
Moreover, he sells (writes) 5 exotic options of the following type:
They are puts, but using as the underlying asset the average of today’s stock price and the
stock price at maturity, rather than using the stock price at maturity as the underlying asset.
The option’s strike is = INR 52.00, the option selling price today is INR 5.00 per option, and today’s
stock price is (0) = INR 49.00 per share. The maturity of all of his positions is = 2 months. What is
ST’s total profit/loss two months from now if
a) at maturity the price of one stock share is INR 57.00?
b) at maturity the price of one stock share is INR 47.00?