EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

EF4420 Derivative Analysis and Advanced Investment Strategies

Problem Set 7

This problem set is to be turned in by Wednesday, April 7th 11:00 pm. Please present your work using MS
Word or PDF and submit online on Canvas. You may use Excel for calculation but the final solution should
be presented in MS Word or PDF.

1. One-Step Binomial Model

Consider a European put with strike price $25 and maturity one year. The current stock price is $25 and
the stock price can move either up or down by 10% once during the life of the option. The risk-free interest
rate is 5% per annum.

(a) Find the replicating portfolio of the option.

Solution: The option payoff is fu = 0 and fd = 2.5. Next, let x denote the number of shares and y
dollar amount of bond in the replicating portfolio. Then x and y should satisfy

27.5x + y = 0
22.5x + y = 2.5

x = 0.5, y = 13.75.

(b) What is the current price of the option?

Solution: The current price of the option is (25)(0.5) + 13.75e0.05 = $0.579

(c) In the real world, risk-averse investors require the return on the stock to be 7%. What is the probability
p of upward movement in the real world?

Solution: p should satisfy 27.5p + (22.5)(1 p ) = 25e0.07 . p = 0.863

1 Instructor: Yongjin Kim

EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

(d) What is the appropriate discount rate for the option in the real world? Does the obtained discount rate
make sense?

Solution: Let rp denote the discount rate for this put option. Then,

0.579 = erp [(0.863)(0) + (1 0.863)(2.5)]

rp = 52.2%. Considering the CAPM, the negative expected return is possible for an asset having a
large negative systematic risk. A put option is one of such examples, because put option pays off exactly
when the underlying stock performs badly.

2. Two-Step Binomial Model

Consider a European call on a stock where the stock price is $40, the strike price is $40, the risk-free interest
rate is 4% per annum, and the time to maturity is six months. One time step is 3-month long and the stock
price can move either up or down by 7% in a step. What is the price of the call option?

Solution: First, the risk-neutral probability is

e0.043/12 0.93
p= = 0.572.
1.07 0.93

The option payoff at maturity is fuu = 5.796, fud = 0, and fdd = 0. Then, the option price is

e0.046/12 (0.572)2 (5.796) + 2(0.572)(1 0.572)(0) + (1 0.572)2 (0) = $1.857.

 

2 Instructor: Yongjin Kim

EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

3. Risk-Neutral and Real World Probabilities

Consider a European call on a stock with strike price $30 and time to maturity one year. The current stock
price is $30 and we assume that there are two time steps for the price to change until the option maturity.
In each step, the stock price can move either up or down by 8%. The risk-free interest rate is 4% per annum.
In the real world, risk-averse investors require the return on the stock to be 10% per annum. In time 0,
what is the probability in the real world that the option will be exercised? What is the probability in the
risk-neutral world that the option will be exercised? Compare these two probabilities.

Solution: The risk-neutral probability of upward movement is

e0.04/2 0.92
p= = 0.626.
1.08 0.92

The real-world probability of upward movement satisfies

(32.4)p + (27.6)(1 p ) = 30e0.1/2 .

Thus, p = 0.820.
The stock prices at maturity are Suu = 34.99, Sud = 29.81, and Sdd = 25.39. Thus, for the option to be
exercised, the stock price has to increase twice. This probability is the risk-neutral world is p2 = 0.392, and
the probability in the real world is (p )2 = 0.673. The probability that the call option is exercised is higher
in the real world.

3 Instructor: Yongjin Kim