Lorenzo Bretscher Derivatives Spring 2023

1. This question asks you to price and describe the replicating portfolio for options on a non-
dividend-paying stock whose price is currently $16. The price evolves on a binomial tree as
follows:
36
↗
24
↗ ↘
16 18
↘ ↗
12
↘
9

The (continuously-compounded, annualized) interest rate is 10%. The time interval between
each stage is h = 6 months (ie, six months from today the price will be either 24 or 12; six
months later, it will be either 36, 18, or 9).

(a) What is the risk-neutral probability of an upward price move, p∗ ?

The risk-neutral probability is
e(r−δ)h − d
p∗ =
u−d
where r = 0.1 is the interest rate, δ is the continuous dividend yield (0 in this case), and
u = 1.5 and d = 0.75 in this case. Substituting in, we find p∗ = 0.4017.
(b) Find the price of the following options:
i. An at-the-money European call expiring in 6 months.
An at-the-money call has strike equal to the current spot price, ie 16. So the option’s
payoffs are
8
↗
C0
↘
0
Therefore the option’s current price, C0 , is e−rh (p∗ × 8 + (1 − p∗ ) × 0) = 3.0568. Its
delta is given by
Xu − Xd
∆=
Su − Sd
where Su and Sd are the prices of the underlying at the relevant nodes (ie, Su = 24
and Sd = 12 in this case. Note that Su − Sd = S(u − d) if the current spot price

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is S and the price can increase to uS or decrease to dS; so the expression above is
equivalent to the one given in class.
In short, its delta is ∆ = (8 − 0)/(24 − 12) = 2/3 = 0.6667.
ii. A European call with strike 17, expiring in 1 year.
The option’s tree is
19
↗
y
↗ ↘
x 1
↘ ↗
z
↘
0
We already have the risk-neutral probability p∗ , which simplifies the calculations.
First, we find the price of the call if the underlying price is 24 after six months. (Call
this price y.) By the standard formula, we have

y = e−0.05 (p∗ × 19 + (1 − p∗ ) × 1) = 7.829.

The delta at this point is ∆ = (19 − 1)/(36 − 18) = 1.

Similarly, the call price if the underlying is trading at 12 after six months is given
by
z = e−0.05 (p∗ × 1 + (1 − p∗ ) × 0) = 0.382.
The delta at this point is ∆ = (1 − 0)/(18 − 9) = 1/9 = 0.111.
Finally, we can compute the call price today, x, using these values of y and z:

x = e−0.05 (p∗ y + (1 − p∗ )z) = 3.209

after substituting in the values of y and z calculated above. And the initial delta is
∆ = (y − z)/(24 − 12) = 0.621.
iii. An American call with strike 17, expiring in 1 year.
We know that early exercise of an American call on a non-dividend paying stock is
never optimal, so the analysis for the American call is identical to the analysis above.
The call’s price and delta are the same, at every node, as in the European call case
above.
iv. A European put with strike 17, expiring in 1 year.
You can either do this using the same technique as in part (i) or you can exploit the
fact that you already know the European call price with strike 17 and use put-call

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parity. Put-call parity says that

C(17) − P (17) = S − Ke−rT

and substituting in the call price C(17), and the values for S, K, r, T given in the
question, we find that the put’s price is 2.591. Similarly, the put’s delta is (by put-
call parity) equal to the delta of the call minus one: that is, it equals −0.379 at the
initial node, 0 at the 24 node, and −0.8889 at the 12 node.
Alternatively, you can calculate the put’s price directly. The put’s value evolves as
follows:
0
↗
y
↗ ↘
x 0
↘ ↗
z
↘
8
Clearly, y = 0 and the delta at that node is zero. We also have

z = e−0.05 (p∗ × 0 + (1 − p∗ ) × 8) = 4.553

and at this node, the delta is (0 − 8)/(18 − 9) = −8/9 = −0.8889. Finally, therefore,

x = e−0.05 (p∗ × 0 + (1 − p∗ ) × 4.553) = 2.591

and the initial delta is (0 − 4.553)/(24 − 12) = −0.379.

(c) Find the delta, at each point in time, of the last two options in the previous part.
These were calculated above.
(d) You sell a European put with strike 17 to a customer at mid-market, assuming the above
binomial tree, and hedge appropriately. Six months pass, and volatility suddenly rises:
you now realize that the price will either double or halve. (So, if the price is 24, it will
now go to either 12 or 48 after a further six months; if the price is 12, it will go to either
24 or 6.) What effects does this have on your position? Be specific: think about things
like how your desired hedge changes, and the effect on your P&L.
There are two cases to consider. If the price is 24, then the value of your hedge portfolio
is zero (because you were replicating a put that would have been worthless in this state
if the world hadn’t changed—look back at part (iv) above). [You can also check this

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mechanically: your hedge position at time 0 was to sell 0.379 shares in the underlying
stock and put 8.662 in the riskless asset. Where does the 8.662 come from? From the
fact that the put’s initial value, calculated as 2.591 above, is equal to ∆S + B. Using
∆ = −0.379 and S = 16, this means B = 8.662. Thus, the value of the hedge portfolio
if the price rose to 24 is 8.662 × e0.05 − 0.379 × 24 = 0 (plus a rounding error).]
The hedge portfolio’s value of zero would have been fine if the world hadn’t changed,
because the option was certain not to pay out. Now, though, you have to replicate a
payoff
0
↗
?
↘
5
Because the binomial tree has changed, you also have to recompute the risk-neutral
probability:
erh − d e0.05 − 0.5
p∗ = = = 0.3675.
u−d 2 − 0.5
Thus, the cost of replicating the desired payoff is

e−0.05 (p∗ × 0 + (1 − p∗ ) × 5) = 3.008.

This is money you don’t have! In other words, you need an extra cash injection of 3.008
in order to continue hedging. You can think of this as money you have lost. Assuming
you get the cash injection, the desired delta is ∆ = (0 − 5)/(48 − 12) = −0.139.
The second case to consider is if the price drops to 12. The logic is identical to before.
The hedge portfolio you chose initially (which would have been fine if the world hadn’t
changed . . . ) is now worth 4.553 (as shown in part (iv)). But you now need to replicate
a payoff of
0
↗
?
↘
11
It is easy to check that the cost of replicating this payoff is 6.6182—more than the
4.553 your hedge portfolio is worth. So, again you need an injection of extra funds
(6.6182 − 4.553 = 2.065). Having got it, your new desired delta is (0 − 11)/(24 − 6) =
−0.611.

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2. This question works with the spreadsheet Binomial Pricer.xlsx, available in the Additional
Material folder on the course website. Assume that the underlying asset’s spot price is $1, its
volatility is σ = 24%, the riskless rate is 1%, and the period length h = 0.01, so that with
twenty periods T = 0.2 years. (As a check that you have the spreadsheet working properly:
the default derivative that is being priced is an at-the-money call option, and you should be
able to see in cell B73 that with the above parameter values, its price is $0.043.)

(a) What are the initial price and delta of a derivative that pays the square of the underlying
asset’s price at time T ?
The initial price is $1.014, and the initial delta is 2.03.
(b) What are the initial price and delta of a derivative that pays the square root of the
underlying asset’s price at time T ?
The initial price is $0.998, and the initial delta is 0.50.
(c) Qualitatively, what can you say about the gamma of the “square security” and the
gamma of the “square root security”? Note that gamma is the sensitivity of the delta of
a derivative with respect to changes in the underlying’s price.
The square security has positive gamma (its delta increases as the underlying price
increases) and the square root security has negative gamma (its delta decreases as the
underlying price increases). You can either use the spreadsheet to see this or just see it
√
directly from the shape of the payoff functions, which look like x2 or x respectively.