12.

19 The current price of a non-dividend-paying biotech stock is $140 with a

volatility of 25%. The risk-free rate is 4%. For a three-month time step:
(a) What is the percentage up movement?
Ans:
u=e σ √ △ t =e 0.2 5 × √ 0.25=1. 133 1

(b) What is the percentage down movement?

Ans:
1 1
d= = =0.882 5
u 1.1331

(c) What is the probability of an up movement in a risk-neutral world?

Ans:
r×△t 0.04 × 0.25
e −d e −0.8825
P(u)= = =0.508 9
u−d 1.1331−0.8825

(d) What is the probability of a down movement in a risk-neutral world?

Ans:
P ( d )=1−P ( u )=1−0.5089=0.4911

Use a two-step tree to value a six-month European call option and a six-month
European put option. In both cases the strike price is $150.
Ans:
A six-month European call option:

T he value is 7.555119≈ 7.56 .

A six-month European put option:

T he value is 14.58492 ≈ 14.58 .

12.20 In Problem 12.19, suppose that a trader sells 10,000 European call options
and a two-step binomial tree describes the behavior of the stock. How many shares
of the stock are needed to hedge the position for the first and second three-month
period? For the second time period, consider both the case where the stock price
moves up during the first period and the case where it moves down during the first
period.
Ans:
15 .00
The delta for the first period= =0.4273
158.64−123.55
0.4273 ×10000=4273
The trader should take a long position∈4273 shares .

Case 1 ∶ If there is anup movement ∶

29.76
The delta for the second period= =0. 7485
1 79.76−1 40
0. 7485 ×10000=7485
The trader should increase the holding to 7485 shares.
Case 2 ∶ If there is a do wn movement ∶
0−0
The delta for the second period= =0
140−109.03
0 ×10000=0
The trader should decrease the holding to zero.