T RENT U NIVERSITY

AMOD

Homework #1
Student name:

Course: AMOD 5520H: Mathematical Finance – Professor: Nick Faulkner

Due date: February 27, 2024

Question 1

Suppose that a particular trait of a person (such as eye colour or left handedness) is
classified on the basis of one pair of genes and suppose that d represents the domi-
nant gene and r a recessive gene. Thus a person with dd genes is pure dominance,
one with rr is pure recessive, and one with rd is hybrid. The pure dominance and the
hybrid are alike in appearance. Children receive one gene from each parent. If, with
respect to a particular trait, two hybrid parents have a total of four children, what is
the probability that exactly three of the four children have the outward appearance
of the dominant gene? (Make sure to explain your reasoning and any assumptions you
have made.)

Question 2

In rural Ireland, a century ago, the students had to form a line. The student at the
front of the line would be asked to spell a word. If he spelled it correctly, he was
allowed to sit down. If not, he received a whack on the hand with a switch and was
sent to the end of the line. Suppose that a student could spell correctly 70% of the
words in the lesson. What is the probability that the student would be able to sit
down before receiving four whacks on the hand? Assume that the master chose the
words to be spelled randomly and independently.

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AMOD 5520H: Mathematical Finance – Homework #1 2

Question 3

This is question 11.23 from the Text

The prices of European call and put options on a non-dividend-paying stock

with an expiration date in 12 months and a strike price of $120 are $20 and $5,
respectively. The current stock price is $130. What is the implied risk-free rate?

Question 4

Suppose that c1 , c2 , and c3 are the prices of European call options with strike prices
K1 , K2 , and K3 , respectively, where K3 > K2 > K1 and K3 − K2 = K2 − K1 . All options
have the same maturity. Show that

c2 ≤ 0.5(c1 + c3 ) (1)

(Hint: Consider a portfolio that is long one option with strike price K1, long one
option with strike price K3, and short two options with strike price K2.)
AMOD 5520H: Mathematical Finance – Homework #1 3

Question 5

This is question 13.19 in the Text.

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 3-month time step:
(a) What is the percentage up movement?

(b) What is the percentage down movement?

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

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

Use a two-step tree to value a 6-month European call option and a 6-month European
put option. In both cases the strike price is $150.

Question 6

This is question 13.20 in the Text.

In Question 6, suppose a trader sells 10,000 European call options and the two-step
tree describes the behavior of the stock. How many shares of the stock are needed to
hedge the 6-month European call for the first and second 3-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.
AMOD 5520H: Mathematical Finance – Homework #1 4

Question 7

This is question 13.19 in the Text.

A stock price is currently $40. Over each of the next two 3-month periods it is ex-
pected to go up by 10% or down by 10%. The risk-free interest rate is 12% per annum
with continuous compounding.
(a) What is the value of a 6-month European put option with a strike price of $42

(b) What is the value of a 6-month American put option with a strike price of $42?

Question 8

An up-and-out barrier option is a type of option that works much like a European
Call option. However, if the stock price gets larger than a certain set barrier value,
the payout becomes zero. A binomial Tree can be used to price this type of exotic
option as well.

Consider an up-and-out barrier European call option on a non-dividend-paying

stock when the stock price is 50, the strike price is 50, the volatility is 30%, the risk-
free rate is 5%, the time to maturity is 1 year, and the barrier at $80. Using a 3 step
Binomial Tree derive the price of this option.