APRIL BO™ Compound Options 30 _—————— - COMPOUND = Option Derivative Seoun : European . European ‘exercise + exercise, dala, Te date Ty z fr dl 0 Te Ty tT The payoff of the compound option is pod. w(V'CR)) The value of tha Underlying option @ time-Te. a... tha. poyoff funchon of the Compound option. Focus on the Following family of options: Ch) ee call fpuk call /putTHe Taste oF Payorrs een neal A Kg. strike of the compound option Tar-Craun Faerrs for Compound options: Coll-onCall (2) — Paton-Call(2) =, Call), - K.en** Call on Rat (©) - Rit on Ral) = Rte) — KeerConsider a non-dividend-paying stock with the intial price of $100. Assume that the continu- ously compounded risk-free interest rate equals 0.05. ‘There is an at-the-money European put option on the above stock with exercise date in 2 years. This option is currently traded at, $11.54. A compound call on the above put option is issued. Its exercise date is one year from today and its strike is 6. The price of this compound call is $7.18. ‘What is the value of a compound put option on the above vanilla option? Pur-call parity for compound ophons: Call‘on: Pu (0) - Raton Rat (co) = Ritlo)- ky & =the AB 2 sh eee"The simplest binomial te, suitable for pricing compound options is a “two- peried hee: Suu Yuu = (K~-Suu) Sud Via = (K-Sua) Sad Vyy=(K-Sad) 4 strike Ke etriken K u altel TT 4 4 Vo -e Lp ais * (4-p*) oven Va [pr Mk + Arp) Nag The possible PY offs of Heo Compotend option: Vu . ( Ke- Va) Va = (Ke ~Va)e => V()=eET[ pF Wa ep Ne] The one proach can be rere ete Tae pal end of tHe ia? penod for some ken, “Thee Teo end of Hae nth ( Cenad) period inthe tre.Canency_Option. pricing . Undurying amet FOREIGN currency [FC] Can erclange poke) w/ F-- Comfnuously compounded, risk-feo interest take for the foreign currency * Domeshe Currency w/ [pe'] the. Continuously Compounds, Wisk rea indicest, t for We domeshc Currency Analogy : Foreign Curren ay >» Continuous -dividend = “paying assis i _ § Q@ Dees tha same anokogy work for binomial option pricing? One -peried X... exch ——— Pernod = eee ee ln 2 REPLICATING P. emu UX) Ve (au) # Aeon, eat x(0) ad nes ph F Q: Use the FoRwAeD BINOMIAL TREE. (a8 He, “default wz e008 8095 +0.3(F = AAG ere Mcgee = 0.36 The rigk-nhewteo? probability » uu? K Xu 24,66 7K x04 w9<— > mua 443 Xg=4.29 ag = 4-06 Compe e_) Nada =“. — home 3 u April 8, 2011luhich tree? The default is FORWARD K=L5¢ ee Gy) A + oll 2 4 ; em Wg 008-008) -§ 40.3 iE =h.d59q yu at eerre) h = ot ae 0.044 = 045 arent Mau Kk run > K ee Mu 4.66 2K ot Xaud “165 >K eG - : Maa 2AM Mg E425 — : / Xudd 24.22. 4 tag* 1.05 1% oo ee eee eye a . P Trot” [pe #6 posi20) Finish this Problem @ home! It ts Sample, MFE Reblem #5 ¢