—— Lesson 20 Binomial Trees—Stock, One Period Reading: Deriewtioe: Markeis 10.1 During this course, we shall learn two ways to price options, The first way (binomial trees) is discrete an totally general, but computationally intensive. The second way (PlackScholes) is analytc, but requlzes several eoumplions and cannot be used generally. This lesson isan introduction to binomial tees, fina binomial tree for an option, we break the time to expiry of the option into periods, In each period, given the price ofthe underlying enset at the beginning of the period, it can anly move to one of two prices tthe end of the period. We can then determine the value ofthe option recursively by starting atthe expiry ate, evaluating the value of the aption tunder each possibilty for final price of the undeztying asset, and then ‘moving backwards through the tree. To start off simple, we will assurne the underlying asset is a rondividend paying stock. The binomial tree will have only one period. In other words, the stock ean only have one of 2 values at expiry ofthe option. ‘Consider the following example: Fora 1-year European call option on a nondividend paying stock’: () The stock’s price is currently 50. (ai The stock’s price will beelther 60 or 40 at the end of the year. (Gi) The strike price is 5. dv) The continuously compounded iskefrce ate is 5%. "The binomial tree for the stock is 20.1. Risk-neutral pricing “Temporarily imagine a ris-netal world, This means, for example that given a choice bebveen having 50 for survand having a random amount of money with expected value 50, one is indifferent, One does not expect 2 risk premium—an expected value higher than 50—to make up for the lack of certainty ofthe payofl 1 2lso ingens that one i satisfied to carn the risk-free rate on a risky asset Tina rideneuteal world, wo-can immediately calculate the probability that the slock price in the above tree ‘will go up lo 6. Namely, the starting price of the stock $0 must equal the average ofthe present valves of 60 dnd 40 weighted by probability. Let p* be the risk-neutral probability that the stock will go up to 60. Then TiSNecav is Betn 192s an Amare al option hs case as the sume premium asa Faropean cal option rrxtstaty Mana tio! panies 287 Sonal Samar28 20, BINDMIAL TREES— STOCK, ONE PERIOD (remember, the rsifree rate is 5% and the period is ene year 0 the discount factor is e~O), 50= €°85(60p" + 4001 —p) 5 (209" + 40) Se“ = 20p" +40 506-40 =a 1256355 Sg = 06268 (062818:s the risk-neutral probability thatthe stock will go up in price. Let's now discuss the option we want to price. The J-year call option has a strike price of 55, This means ‘that the option will pay 5 If the stock price is 60 and 0 ifthe stock price is 40 atthe end of the year. We ean update our tree by placing the option values below the siock prices: weet me 30 (65,1) Asin the previous lessons, C(S5, 1) isthe call option promium fora L-year option with a strike price of 53. Using the risk-neutral probabilities we developed above, the option premium must be the expected present value ofthe two ending prices, or (55, 1) = «-?9°((0.62818)(5) + (1 -.62818)0) So the option premium is 2.9977, and the tree locks like this: “0 5 30 a 29077 TEs 40 ° given’ () The current stock price is 50. (ii) At the end ofa year, the stock price-will be either 40 or 0. (Gi) The risk fre rate 95% Determine the premium for the put. a (Quiz 204 A 1-year Buropean put option ona nondividend paying sock hasa she price of 50, You are IPS Manon ton 2 peng Cope can a202. REPLICATING PORTFOLIO 239 .—— ee ai —— 50: 48: == — 40) a 38.4 ie 32: pce Ore “286 re mac isan oes 2.4=08 Ifa call option pays off at both the upper and lower node, then the put option with the sime expiry f and strike price is worthless, In this case, the Value of the eall option, by put-call party toa put of value Ui8, CUA) = Ser* = Kerr? Similatiy, sf put option pays off at both nodes, its value is PUK,#) = Ke? Se ‘Wennow introduce the notation 1 and d in the binomial tre to indicxto the constant to omultiply the initial ‘value by to get the upper (1) and lower (4) nodes, In the above example, = 1.2and d = 0.8, 80 that the inital price S = 50) goes either to u5 = (1.21(50) = 60 or dS = (0.860) = 49. When we generalize to « multl-period ttee, and d will not vary by period. Thus a 3-period binomial tree built with the same parameters as above ‘would look like Figure 20.1. ‘One of the repeating themes ofthis course is that an opticn can be priced using rsicneutral probabilities discounted at the riskefree rate, Many students get so excited by this, they forget that riskneutrel probabilities are purely a mathematical concept and de not represent the probability of anything. ‘The risk-neutral probability is purely a mathematical concept and does not represent the prob 1\ ability of anything. If 2 question asks you for the probability of an event and does not qualify the word “probability” with “risk-neutral”, state the true probability. Do not answer with the| risk-neutral probability. 20.2. Replicating portfolio Originally, the binomial model was priced by creating a replicating portfolio for the option, one that hes the same outcomes in all scenarios ae the option. As we shall see, no assumption about probability is needed to construct this portfolio. Te Ine f ne price says that i two portfolios lead tothe same outcomes inal scenarios, they must have the same price. In a universe with no erbitrage, the law of one price must hold; othervrise ‘one could buy the cheaper portiolio and sell the more expensive portfolio. It turns out that using risk-neutral pricing is equivalent to pricing with replicating portfolio; this is how the validity of risk-neutral pricing Was proved. Given that risk-neutral pricing s easer to calculate, that fs the method you will usually use. However, let's discuss how one would build a replicating portolo. ‘We replicate the option with 2 portfolio of number of shares, which we call A, of the stock. and an investment in the amount of 8 in a riskfree bond. (B stands for bond, not for borrowing—in fact, I Is the amount we lend, not borrow!) Let's return fo the call option we discussed above. For convenience, the example is repeated: ai coos eva Eat Tw one price des tpl thelack ef arbiage TAS Mama an Corgi oa AB260 STOCK, ONE PERIOD Payot 0 s p 40 30 60, % 0 Figure 20.2: Pay ol epleang prt fr thecal option dlecusodin he tort, consisting 0 0.25 shares of tock ‘and a loan af 8.51229, The neavy dts at 5; = 40 and 50 represent tha payot ol tne call apion, Fora -year European call option on a nondividend paying stock () The stock's peice is currently 50 (i) The stock’s price will be either 60 or 40 atthe end of the year (ii) The strike price is 55. iv) The continuously compounded risk-free rates 57. ‘The option pays 5 if the stock goos up in price and 0 if it goos down in price. We shall create a portfclio ff stacks and bonds that also pays 5 the stock goes up in price and (if t goes down in price. We can write ‘two equations in two unknowns (A and 5) by equating the ending payoif of the replicating portfolio with the ‘ending payolf ofthe option for an increase and a decrease in the value of the stock: Increase OA eB ES Decrease 404 +698 = 0 We conclude: 40k +08 404025) = =10 9.51228 So thereplicatingportiolioconsisisof buying (.25shares of thestockand borrowing 51209, Thenet investment 150.2550) ~ 951229 = 2.98771, which is therefore the premium forthe option. ‘The replicating portfolio pays an amount whieh i linear funetion of the stock price; thus we ean graph its payoi forall values ofthe stock price at the end of ene year as in Figare 212. However, there are ony va [possiblities forthe stock price accorcling tothe binomial tee. Creating the replicating portfolio x something like drawing a line between two points! ‘You don't have to go through al the algebra to get the replicating portfolio. You can reason it out, The range of ending stock priccs the difference between the highest (60) and the lowest (40)—ie 20. The range ‘of ending call payotts—the difference between the one corresponding to the highest stock price (3) and the ‘one corresponding to the lowest stock price ()—is 5. Since the replicating portfolio Isa linear function of stock prices, this means that A, the coefficient applied wo dhe stochs, i the rio ofthese differences: $. The intercept the maturity value of she amount to lend i the balancing stem, eMstcy Mana en par, Clpyrg Ca Ae202 REPLICATING PORTFOLIO ze sven: ()) The current stock price is 50 (id) At the end of a yee; the stock price will be elther 40 oF 6. (ii) Therisk-free rate is 5%. “The replicaung portfolio consists of A shares of stock and of londing B. Determine 4 and B, % ‘Guis 292 A -year European put oplion on anondividend paying todchas a strke price of 50. You are ‘You should beable to reason out the option premium, A,and 5 withoutmemerizingany formulas. However, {shall provide formulasif you like memorizing, Before] do le’s generalize to stocks with continuous dividends. Suppote inthe above caloption example that the stock paid ad = 2% continuous dividend. Using sk-nevtral pittablities, in order to have 1 share of stock at the end we only need ¢~° shares initially, 50 we equate that Starting value tothe present value of the ending values, or 50-82 «D5 (4011 — p*) + 60p") =e Dp" +40), 50e%9— 40 _ 1.52273 Set =H - HS? _ ogre ‘The call promium is then 05761445)2°% = 2.7402. “To calculate the eplicating porlilio if we invest in 1 share of stock the difference between high and low ending values is 20¢4'= 20, whereas the diference in ending option values is 5, 90.4 = gy = 0.24506, Then we solve for B Atade + Be = 0 (0.24505) (40}e + Bes {0:24505)(40)<-°% ‘The call premium is A(G0)~ 9.51229 = 2.7402. ‘Quiz 203 Consider a 1-year European put option on the above stock, Le, a stock with 2 continuous vidend rate of 2%. Use the same binomial tree and the same risk-ree rate, 5% as the previous quiz, ‘However unlike the previous qu, the strike price for this quiz is 58 4. Calculate the replicating portfolio and derive the option premium from it. 2. Prove that your answer to the fist partis correct using pul-call parity, using the call option value we just calculated. Fora general formula et S be the original stock price, C, and Cy the value of the (call or put) option atthe upper and lower nodes respectively. Let's assume lt years (instead of 1) toexpiry. The rumis uS 48 = (4—<)S ‘and we will invest in €-*" shares, The difference in call values at the end is Cy ~ Cy- So eon rosy Namal ie os262 20. BINOMIAL TREE: STOCK. ONE PERIOD We seve for B: ASue!* + Be" Bim Gi os) th Bi (Seem) sue 8 (Sopot on u(Cu ~ Cy)’ neon, MEE % (202) ‘The option promium is then AS + 8 ‘The general formnla forthe risk-neutral probability is derived as follows: weequate Se~, the present value Of the stock based on the starting price, to the expected present value of the stock price at the endpoints, eo (pts +(1 ~p'ds) Wecan cancel the 5,50 Se (pry 4 (= pd) = (pu —d) +a) from which it follows, 03) Multinomicl Trees So far we've been dealing with binomial tees. A tree with more than 2 branches can also be valued with a repliceting portiolio, as long as there are 1! ~1 diferent assets for an n-way branch, The SOA formerly included a question on multinomial trees in their sample questions, but removed it in the updated list for the July 2017 syllabus, Perhaps this means that they don’t intend to ask such questions in the future. 1fs0, you may skip this section and the exercises on this topic Exanmur20A_ You are given 2nondividend paying stocks, X and Y. The current price of eachione is 100, After 1 year, there are three possibilities for their prices: ‘Outcome | Frice of X | Price of Y T Ta 150 2 100 uo 3 95 70 Let C(X, 95.1) be the price of @ European call option on X with strike price 95 and 1 year to expiry. Let P(Y,90, 1) be the price ofa Furopean put option on Y with strike price 90 and 1 year lo expiry. ‘The continuously compounded risk-iree rate is 10%, Calculate CX, 55,1) + F(Y,90,0). Awswi: Let Ax be the numbor of shares of X to buy and Ay the number of shares of ¥ to buy. Let 3 the amount of risk-free bonds to buy. The replicating portfolio is AxX + AyY +B, and must replicate the three FEN sty Marea ton 2 printing Copyaght ean St203. VOLATILITY 263 ‘outcomes, The cell pays 35 and 5 at the top two outcomes, and the put pays 20at the lowest outcome. So 130A + 150Ay + Be?! = 35, oody + 1oay + Be dx + TOAy + Bed =20 Eliminate Be" by subtracting (") from (and (*) from (*). 30Ax +40Ay = 30 oO) Bay + M0dy = 15 a Subtract (44) from (4) tocbtain Ax = § = 1.8. Substitute into (+) to get Ay = 23408 = -0.6. Then substitute {nto one of the three orignal equations to get Be™ = ~108, or B = ~109e~, The option portfolio is worth AxX(0) + Ay¥(0) +.B = 100(1.8) + 100(-0.6)— 109" Itisalso possible to sole this example using risk-neutral probabilities, Let p} be the probability of outcome i. Then pi +p +p) = Land 00e"* — 95 one? — 70 1309; + 10095 +9501 = 75 = #5 359} + 5p 109+ 11095 +70€.~ Fi -P 0p +405 Multiplying the first equation on the sight by 8 and subtracting the second, we get 200p5 = 7002! — 660, or one 95-2675 ‘ng #0 — 9.418098, ‘Thon p = APN — 0.176731 and py = 1 0.418098 ~ 0.176791 = 0405171. Fhe vaksS5e te option portfolio & €-9(0.418069(25) +0.17673166) + 040817120) = [E37] ° 20.3 Volatility So fas, we have picked arbitrary 1 and d, Let's not be 0 arbitrary now: We can't make 1 100 low or d too high. ‘The upper node must be higher than the result of a risk-free investment, and the lower node must he lower, or else arbitrage would be possible: either the stock would, always be better than a risk-free investment (in which case you'd borrow as much as you could and buy the Stock) oF it would always be worse (in which case youd short the stock as much as possible and lend the proceeds). A risk-free investment of § produces Se", whereas the stock produces Se", $0 dx ey (204) ‘Se(-9! isthe forward price ofthe stock, so we coald also say thatthe forward price ofthe stock must be betiveen the upper and lower nodes (i) The initial price ofthe stock i 43.35, (i) The continuously compounded risk-free interest rate is 7% (ii) The etock pays dividends at a continuous ate of 3. Detezmine the greatest lower bound for values of the stockat the upper node of the binomial tree. Q) ‘Quiz 20-4 A period binomial Ire x constructed for afmenth option on astoek. You are given. Tratsaty Nal ton 2" pong ees torre264 20. BINOMIAL TREES—STOCK, ONE PERIOD ‘The further apart w and d are, the greater the variance in the stock's price. Rather than considering the variance of a variable assuming the values u or d, consider the variance of a rancom voriable assuming the vvaluos Ins and Ind; in othor words, the variance ofthe continously compounded rate of return. Bemoulli random variable equally likely to assume the valves 0 and 1 has variance 0.25. Hencea random variable equally lukely to assume the values Inw and Ind has variance 9? = 0.25(In u ~Ind)? = 0.25{n®(u/). While our trees do not have probability 05 of an up move, we will calculate the variance as ifthe probability Is 05. ‘Then solving ford in terms of x, 20 = In(u/d) vw is the square root of the variance, or the voizility, for one period. We annualize it by dividing it by Vi, ‘where f isthe size ofthe period. Thus © = o/ fi, where o ts dhe annual volatility. And from the above, = 0.5in(u (avi. ‘When we tlk about volatility or 0, we always mean annual volality unless we specify different period. ‘To specify values of «and d, we frst specity the volatility ofthe sock. Then we can pick any we want, and st = 629% ats discuss one specific way to specify u and d. By an arbitrage argument, we can show tha the price at the upper node must be atleast as high asthe forward price and that the price at the lawer node must be no higher than the forward price. To guarantee that u and d satisfy this property we set u = (Foy(5)/So}e?™® ancl 4 = ya )S)e"™4 where Sos the price of the aset at ime O and Fy. the forward price for period h Recall that Fen = Se" 50 = olan seth oa) a When w and ¢ are specified in this manner, we will say the tree is based on forward prices. On exams, they ‘will call this too the forward tee and may als refer to “the aswal method in McDonald” when they want you to-use these formulas for w and d_ \, Thetree speciied by equations (20.5) isthe most commonly used binomial tre inthis course, but 1\, isnot the only binomial tree possible. When u and d are specified by a question, use these values, —) Donor indopendentycalulateu and d Exawer.s 200 A 9-month put option on a stock is modeled asa binomial tee. You are given: () The stock price i 75 (ti) The strike price is 80, (ii) r =008, liv) 5 = 0.02, @) 6=03, Determine the premium of the put option. ANswar: We calculate w and d. w= el -Brev = (oen-00090.2)102900 05 = 1.17939 8 = garara dace ~ glo 0001025)-0.3905) {Patsy Mara etn prs, Ccpngi cans krEXERCISES FOR LESSON 20 265 Now we calculate the risk neutral probebility of an increese in price using equation (203). ud 05025) _ 0.87372 Tie — 0.87572 ina eg = 06257 The payoff ofthe putts ‘max(0,80— nS) = man(0,80 ~1.17939(75)) = 0 at the upper nade and smax(0,80 ~ 45) = max(0,80~ 087372(7)) = 14.471 at the lower node. The put premism is 098025 jpr(0) + (A= prYL4.A7I)) = €-PM%(1 —0.46257)(14.47151) When a binomial tee based on forward pricesis used, there isa shortcut formula for p™. Let F =e!" and of, Weeonclude that Tee (a8) ita data inte on ug gs nw oud ae ted The pty dyno verse cain Exercises Riek-neutral pricing 20.1. Stock prices are modeled with the following I-period binomial tree, the period being, 6 months: Fora European call option on the stock expiring in 6 months, the tke price is 52 The continuously compounded rick fre interest rate is 6%, Determine the change in the premium for the call option if the continuous dividend rate for the siock increases from 0 40 2% Tu stay Mano etn 2 pent ec sti on fee pg Copmasto8 AGM266 20, BINOMIAL TREES—STOCK, ONE PERIOD “Table 20.1: Formula Summary for Lesson 20, nay 02) ua etomel, g for forward tree 205) iro oe (202) for forward toe a6) = food re (07) c=sase cas) Cyt (=P Ca) a9) 202. Prices for a Stock are modeled with a 1-perlod binomial tee with 1 months, A Buropean call option on the stock expires in 3 months. Youare givers () The stack’ initial price i 60. (ii) The stock pays no dividends. (ii) The trike price fr the call option i855. (y) The price ofthe eal option i 3.10. Determine the continuously compounded riskcfree interest rate. 2, d = 07, andl a period of 3 203, The fature prices of a stock are modeled with a I-period binomial tree based on forward prices, the Period being one year, (The current stock price is 40. (i) The continuously compounded risk-free interest rate is 57 (ii) The stock pays continuous dividend proportionate to its price a arate of 2%, ww) 3. Determine the risk-neutral probability of an increase in stock price, CipynieM CX08 ASN tor 2 painting ecco on te nex pa.EXERCISES FOR LESSON 20, 267 ‘Future prices of a stock are modeled with a 1-petiod binomial tree, You are given: (The stock's current price is 4. 8) The contingovsly compounded risk-ree interest rate i 5%. (Gi) The stock pays no dividends. Gv) w= land d =08, For a European put option, the strike price is 40 and the price is 3.12, Determine the time to expiry for this option. 205. Prices ofa stock are modeled with a l-period binomial tree having 2 period of 6 months. You are givens (‘The stocks initial prices 40, (u) The continuously compounded risicfree interest rate 85%. (a) The stock pays continuous dividends ata rate of 2% (¢v) The risk-neutral probability of an increase in stock price 8056. (¥) Inthebinomial vee, 1 and d are selected so thet their arithmetic average i 1 A Buaropean call option on the stock expiring in 6 months has strike price 45, Determine the option premium. 206. [2-FOL25] A stock currently has a price of 45.00 and pays no dividends. One yeer from now, there is a risk-neutral probability of 50% thatthe price ofthe stock will be 30.00 and a risk-neutral probability of 50% that it will be greater than 40.00. ‘The effective annual risk-free interest rates 4%. Calculate the price of a one-year European call eption with an exercise price of 40.00. (a) 481 (@) 65 © 981 (D) 10.00 @® 135 207. [2-80.30] A stock price can go up by 20% or down by 15% over the next year. The current siock price ‘s greater than 70. You own a one-year puton the stock. The put has an exercise price of 78.26. The effective annual risk-free interest rate is 11.25%. The stock pays no dividends, If the put is exercised today, the amount received will be X. The price of the put today (unexercised) fe also X. Calculate the current stock price (a) 7450 700 (© 7650 © 7300 ©) 78.25 208. [2-FOT:40) A non-dividend paying company stock is currentiy treding at 50. Over the next year, this ‘stock will either increase in value by 10% or decrease by 2%. The effective annual risk-free interest rate is 4% ‘The value of a one-year European put option for this stock at an exercise price of 50 is 128, Calculate (ao 2 o-4 6 es rrusiy Mama an 2 pg eco contnaé on tea Cope cas A me268 20. BINOMIAL TREES STOCK, ONE PERIOD Replicating portfolio 209, The price of a nondividend-paying stock is modeled by the following l-period binomial tree, with each period being one year: 0 sos = ‘A Enropean call option expiring in ane year on the stack has stske price 30 ‘The continuously compounded risk-free intorest rates 4°, Determine the numberof shares of stock in the replicating portfolio forthe call option, 25 20,0. The price of anondividend-paying stocks modeled by the following I-period binomial tre, with each period being one year: wo" ss A Buropean put option expiring in one year has strike price 38. ‘The continuously compounded riskcfree interest rate is 4% Determine the amount of money borrowed in the replicating portfolio forthe put option. 20.11. The price of a stock is modeled by the following 1-period binomial tree, with each period being six months: ‘You are given: () The uncerlying stock pays continuous dividends proportional to its prise ata rate of 2%. (ii) 4 Furopean call pption expiring in 6 months has strike price 20, (i) The continucusiy compouncled risk-free interest rate is 5%, Determine 4, the numiber of shates of stock in the replicating portfolio for the call option. 20.12. Fora I-year Europeancall option on 2 nondividend paying stock 2 1-period binomial tree isconstetetod. You are given: (i) The stock price is 45, (i) Thetrechas u= 1.2andd = 08, (it) The continuously compounded risk frve interest rate is 4%. Gv) A replicating portfolio has 05 shares of stock. Determine the strike price of the option. atstny Mala etn png, nee cote het ag Cepora oa aEXERCISES FOR LESSON 20 269 20:3. Stock prices for a nondividend peying stock are modeled with the following t-period binomial tree, twith the period being 6 months <=” 30 ‘The price of « European call option expiring in 6 monthe with strike price 60 is 1.00. “The continuously compounded risk-free interest ate is 5%. Determine the price of the stock. 2014. A European call option oxpiring in one year-with strike price 50 has premium 500. The underlying stock pays continuous dividends propersional to its price at a rate of 2%, The continuously compounced free interest rates 6%. “The underlying stock's price is modeled with the following binomial tree having one period of one year. oe a 40 ‘You will construct an arbitrage using only the stock and call options. Determine the amount to borrow or lend in orcer to immediately gain 100) through a combination of ‘transactions that cannot lead to a future loss, 20.15, Future stock prices are modeled with 2 I-pericd binomial tee, the period being 6 months. (The stock’s current price is 20. (i) The continvously compounded risk free interest rate is 3%. (iil) Thestock pays continuous dividends proportional to its price ata rate of 1%. The number of shares in the replicating portfolio for a European call option on the stock expiring in 6 months with strike price 201 0.4 Determine the number of shares in the replicating portfolio for a European put option on thestock expiring in 6 months with strike price 20. 20.16, Future prices ofa stock are modeled with a I-period binomial tee with 1 ‘the period ss 3 months, You are given: (0). The stock price is 6. (ji). The continuously compounded risk-free interest rate is 5%. (il) "The stock pays continuous dividends proportional to its price ata raie of 5% 2, =0.8, The length of For # European call option on the stock expiring in3 months, 40 is borrowed in the repitcating portfolio Determine two possible values for the number of shares of stock inthe replicating porto. 1M Siicy Maras etn ping eres contnue on ten Pe. {Copa ons270 20, BINOMIAL TREES—STOCK, ONE PERIOD 20.17. You are given the following binomial tree, with a peried of 6 months, for stock prices. On the tree are prices for 2 European call option on the stock that expires at some time later than 6 months Stock price: 55 Dption value: 18, Stock price: 50 a Stock price: 45 Option value: 11 ‘The continuously compounded risk free interest rate is 5%. The stock pays continuous dividends propor tional to its price a arate of 3% Determine the number of shares inthe replicating portfolio for the option atthe initial node 20:18. [Based on CASS-S01:29b] You are given the following information: (i) Tho current price ofa share of XYZ Company stock i 100. (ii) Over the next sicmonth period, the price is expected to go up by 10% or down by 10%, (il) Tho riskfeco rato of interest with semi-annal compounding i 6% per annum. Gu) The stock paysno dividends A special option pays 544 f the stock price goes up and 25.00 ifthe stock price goes doven. Determine the number of shares of stock in a portfotio which replicates this option. 20:19. [CAS8-S04:27] A nondividend paying stock’c price is currenily $50.00, itis known that st the end of "hwo months, it will be either $54.00 or $46.00. The risk-free interest rate is 90% per annum with continuous compounding, Calculate the value of two-month European call option with a strike price of $48 on this stock. 20.20. [CAS8-S04:28] A nondivicend paying stock’s pric is 45. At the end of six months it can ge either up 6.10% ar down 60% ‘You have sold 1,000 sic-month European call options on this stock with a strike price ofl. Caleulate the number of shares of stock that you would need to purchase in order to create ariskless hedge, Volatility 2021, A I-period binomial tree is constructed fora 1 year European option. You are given: () The initial value is 50, (i) The value on the lower node after one period is 49. (Gi) The continuously compounded risk-ee rate is 5%. (iv) The underlying stock pays continuous dividends at arate of 9% [Determine the greatest lower hound of the possible values on the upper nade after one period ‘estoy Masaki" ean prnarg, xcs coutmueon the Carma eis Aa meeEXERCISES FOR LESSON 20 2 2022. The price of a stozk is modeled by the following T-period binomial tree, with the pertod equal to 6 ‘month: ee 50 —_. You are given: (i) The continuously compounded risk-fre interest rates 6%. (3). The underlying stock pays dividends at a continuous rate of 2%. semust be inthe range (0,0) Determine 2023, Ina one-perod binomial te fr stock pices, you are given: (a) The period ofthe tree is 6 months. (i) Ses the initial price ofthe stock. (ii) ‘The price of the stock may be 0.85y or 125¢ a the end ofthe pesiod. Determine the volatility ofthe sock price Ls ie olan nyormaton for questions 2024 and 2025: Fatare prices of @ stock are modeled witha T-period Binomial x based on Forward prices, the period being 3 months. You are given (8) Thestock pays no dividends. (i) The tock’ inital price is 25. 3) The continuously compounded risk-free interest rate ts 4%. 2021. A Europesn call option expiring in 3 months has strike price 24 ‘Determine the change in the price ofthe cal if the stock's volatility increases from 20% to 30% 2025. A European call option expiting in 3 months has strike price 20. Determine the change inthe price ofthe call if the stock's volatility inereaces from 20% to 30% 120126, Future prices of a stock are modeled with a 1-period binomicl tree based on forward prices, the period being 3 months. W) Thesteck ps (i). Thestrike price is 26. li) Thecontinuously compounded risk-free interest rate is § {iv) Thestock pays continuous dividends at arate of 3% @) @=02 ‘A European call option on the stock expiring in 3 months has strike price 26. Determine the number of chares inthe replicating portiolio for the call option. ty Nansen ari sontinicon Be 8 page pon Oia2m 20. BINOMIAL TREES. STOCK, ONE PERIOD. 20.27. Future stock prices are modeled with a I-period bincmial tree based on forward prices, the period being 6 manths, You are giver (The stock’s current price is 4. @y u=13 (i) The continuously compounded risk-free interest rate 18 4%. Gv) The stock pays dividends at a continuous rate of 2%, Determine o. 20.28. Future prices ofa stock are modeled with a 1-period binomial tree based on forward prices, the period being one year. You are givers (i) The stock’ current price is 35 ii) The continuously compounded risk-free interest rate 1s 5% (ii) The stock pays continuous dividend ata rate of 10%. (w) 9 =02, ‘A European put option expiring in one year on the stock has strike price 40. Determine the amount of money borrowed in the replicating portfolio fer the put option. 20.29, Future prices ofa stock are modeled with a 1-period binomial tree based on forward prices, the period being 1 year. ‘You are givers (i) The stock price is 30. (ii) The continuously compounded risk-free interest rate fs 5%. (ii) ‘The stock pays no dividends, (iv) 90.25. (W) Fora European call option on the stock expiring in one year, the replicating portfolio has 0.9 shares of stock. Determine the price of the call option. 20.30. Future prices of a stock are modeled with a L-period binomial tree based on forward prices, with a period of one year. You are given: (i) The continuously compounded risk-frce interest ate is 6%. (i) The stock pays continous dividends proportional to its price at arate of 2% (ii) The viskeneutral probability ofan increase in price is 0.45, Determine 0. Sy Manan. rae Exeres cantina on then ageEXERCISES FOR LESSON 20 23 2031. _A put option is priced using « one-period binomial tree based on forward prices for the underlying, stock. You are given: ()‘Theperiod of the trees three months. (W)_ The option expires in three months. (Qu) The current price of the stocks 80, (tv) Thestock pays no dividends. (9) The continuously compounded risk-free interest rate i 0.1. (of) The srike peice of the option fs 60. (vit) The resulting price of the option is 2.50. Dotormine the volatility of the stock price The foliowing exercises involve multinomial trees, While you should be able iodo them, you may skip them, since it appears that the SOA doesnot intend to ask questions on this topic. 2032. For two nondividend paying stocks $ and Q, the current prices are §0 and 100 respectively. There are three possible outcomes for their prices after 1 year Ouicome [Trice of | Pave | 1 0 30 2 0 100 3 o 200 An option portfolio consists of a European call option en S with strike price 50 and a European call option ‘on Q with strike price 9. The continuousiy compounded risk-iree interest rate is 0.5. Calculate the price ofthis option portiolio. 2053, Fortwo stocks X and Y with prices X(t) and Y(H), () Xi =40 (3) X pays dividendsat a continuous rate of 2% (iu) Y doesnot pay dividends. av) After 6 months, the possible prices for X and Y are ‘Ouicome [Price of X | Price of 1 30 70 2 50 30 (0) The continuously compounded sak ire interest rate O08, Determine the current price of ¥ MSiny Maral atin ping, xn tinea te paseca 20, BINOMIAL TREES—STOCK, ONE PERIOD 2034. [Former MFE Sample Question 27] You are piven the following information about a securities market: (There are two nondividend-paying stocks, X and Y. (W) The current prices for X and Y are both $100, (i) The continuously compounded risiefree interest rate 10%. Gy) There are three possible outcomes forthe prices of X and Y one year from now ‘Outcome |_X | T $200] 3 2 | $50 | $0. 3 | so [sw Let Cy be the price ofa European call option on X, and Py be the price of European pat optionon Y. Both, options expire in one year and havea sirike price of 925. Calculate Py ~Cx. (A) $430 (B) $445 (© 8459 (@) 9475 (B $498 Additional released exam questions: Advanced Derivatives Sample:s9, CAS¥S7:15,16, SOA MFE-S(7:14, (CASO-TU77,19,23, MFE/IF-809:3 Solutions 204. We'll compute itboth ways using risk-nevtral probabilities. The risk-neutral probability is Md BeOOMOHES — 49 WT 13e-9 times this. For 5 and the call premium is ¢-° (65 —52) set a0) and for 6 = 0,02: ‘So the change in premium is 13e~*(0.440405 ~ 0.460909) Analtornaiive method isto use the replicating portfolio. E does not depend on &, 60 only A changes. = (S262), 38-0 i= ay) = 5 0.8 changes by () (e802 —1) = -c.0n517408, The change mall premium is then S umes the change in 2, or 50-0.00517809) 202 The stock can rise to 1250) = 60 or fall to 0.7150) = 35. The call pays 5 Wit rico, The call premium’s ‘equation using riskeneutral probabilities is 8.10 =5p'e 8 fet ~0.7) assy 12-07 = 10 (1.7435) ore spsstgy Mara aon = pt reas Oa A masEXERCISE SOLUTIONS FOR LESSON 20 275 0.59 O7 tin 203, Wedetermine the upper and lower nodes: dee-oro Ten nee 763379 ee 204. The stockcan go up lo 4 (no payofi) or down to.32 (payoff of 8). The risk-neutral probability of «drop is 1ane 12-00% 12-08 ~~ OF ‘The put premiumis 2-009" 1) p(t 1) Setting it equal to3.12: 29 (1.26% -1) =3:12 own 92, eS a 0a 1.156 _ 9 965539 0 = EES = 9 (0.058 = —1n0.963233 = 0.007356 ‘The option premium is (us — Kyp'e = ((0.151131}(40) ~45)(0.88) (e-2) = Srertaras te216 20. BINOMIAL TREES—STOCK, ONE PERIOD 20.6. We know that the forward price of the stock must equal the risk-neutral expected price, so the price 45u: at the upper node must satisfy 304450 45.08) = 28 Su= 636 Then the price ofthe call option ts 0.5(63.6 = 40) e 104d © 120.7. Let S be the stock price. The exercise value is 78.26~ S. The option will net pay if the stock price rises, since 1.25 > 1.2(70) = 84 > 78.25, The risk-neutral probability of rising is 1125-085 12-085 ‘Thus the pulled back value is 0.25(78.26 ~0.85S)/1-1125. Equating the two value, 0.25(78.26—0.855) 11s = 1753652 — 0.191015 o.8099896 = 60.67048, P 7s 7826 @) 20.8. i fscaster to work with e call than with a pul, since we krow the payoff of the call. By put-cal parity, xo 1.28- c= 3-50 50 C= 128 +50~ 5; = 3.20208 Lety be the stock pric fi decreases. Then the rskneutral probability ofan increase s _ 50008) -y _ =v P= Saajay ~ By ‘The price of the calls then determined from _PG5~50) 108 Rau 5 Bay (to Sy B-y 36.6492 —0.65624y = 52 y 15.3568 ons Thenx =1-460118/50 -[0833] (©) TP souy sma etn ping, Cepyngh 8EXERCISE SOLUTIONS FOR LESSON 20 a7 209. The call is worth C, = 10 at the upper node, C. atthe lower node, By formula (203), ‘This isthe bord parchassd co the oplining portfolio bors [=IBAET} or eds 25.521 Med Tene the al pye a wheter the tod iss orale =0 Cy Ca = SU Sd, and formula (D1) gives Ce Bozo ‘Assume Ci =O If this does work we can correc later) Ther (05145)04) =9 so the ire price mut reultin a pays of ifthe stock ges up, oF 41.2)~9 = [8] 283, Thecall premiums 05 c 99625) 9*(100 ~60) + = e005 90 yo) But pis: ‘Am alternative method to solve the problem isto compute the replicating portfolio. While we do not know word, wedoknow that Su 9,20 we can compute B by multipiving formula (20.2Y's numerator and denominator by on. (49-9, ioo=s3) 7 —3e.n240 Wo are given tat the premium 1.00, s0 1.00 = 5(08) -99.01240 on +3201240 | 5 Mee 5001550) MASmly Nn otto 2 ping, Soop eabaAa7 20. BINOMIAL TREES—STOCK, ONE PERIOD 2044. For one call option, ee (& —S-8 (@ 0M = 9.588119 ane (ee Jecmml 5(0)~ 0.845) und (13-08 | C=AS +5 = (055811980) -22.00235 = 6.2056 ‘Thecalltsundespriced at 5.00 'youbuy one cl for 5.20 andsell it ors true price, you make 6.8035-5 = 1.5136 profit So tomake 1000, youmust replicate ky = 5.5444 call. You buy 5.5444 call (since they teuneerpriced), ‘nd sll the replicating portfolio for 354444 call, In other words, you sllchor!5.5444(0 588110) = 3.2608 shares ‘of stock, and lend 5.544432(22.60235) ‘The cost of the calls is 5.5444(5) = 27.722, so the total cash Flow out i 125317 + 27.722 = 15806, The proceeds from selling stock short are 3 2608(50) = 163.04. You have made 10 prof 2035, Thebest way to do thisis with pucall parity, We have C_Pm se-0809)_ x, 02903) Pa C—Ser0005 5 Ke-008 So we sce that 2 put consists of a call minus ¢~8 shares of stock plus Ke“®®"* in bonds. Ane we are given that a call is replicated with 0d share of stock. So the number of shares of stock to replicate a put is ot «0s ~[“p.59s010 Alternatively, we can prove that the call only pays oif at the upper node and the put at the lower node; f the call paid off at both nodes, then the replicating portfolio would have e~* shares of the stock, so that 4 = e946, but we are given that A ‘Therefore, the formula for A for the call (which pays 204 ~ 20 atu) is {204 — 20) 200 and the formula for A forthe put (which pays 20 20d at d) is 20 — 201 Ap = ett lan a) Subtracting, Ac ~ Ap = eM ~ e280, from which it follows that 4-08 ~ [a s500 20.416. Fora I-period binomial tree, UeCy > 0, then Cy = Sd~Kand Cy “(=a) IECy = 0, then using equation (20.2, maxi0, Sd -K). Su=K,s0 nm AS -o25(-08C. Ta=0. w= eR C,) Say Mad" etn? pre Copenh ca keEXERCISE SOLUTIONS FOR LESSON 20 279 ‘Then using equation (201), 2017, Theo optionvales wou stars normaly a -period te but cul sen a ule es fee wills mthe nox eseon a 20. For ¢ =0.3) w= OMMHO5) 2 1.179511 d= -€209 - 9365558 dS = (01859358)25) ‘Since the option pays off regardless, it is worth the discounted value ofthe expected payoft, which is the ‘exces ofthe formal price ofthe stock Qe") over thestrike price. Thisworksout oe °- 252-29) = 520, bat you don't need to ealeuate this) Sinee the option is worth the seme for both volatilities, the diference is 20.26. aelt-DheoNh - (o1s-n0y025.02005 = e901 = p65 =. Qn0973 sao By formula 20.1), Gs and in this case Cy, = 25(1.110711) 26 ~ 1.767765, Cz =0. 67768 rrr ovonaran) ~ 0992528)0351208 20.27. rho 13-0 In13=0014 VIR 0252364 = 0.014 VTE {Puta Minti atin 2 pining Eee cam aeEXERCISE SOLUTIONS FOR LESSON 20 2s 0.252364 = oyT/I 0.52364 ae 2028, Fore put, the replicating portolio lends money so the answer will benegative. The upper nodeis t= e212 = 1.16183 and the lower nodets d = MP" = 0.77650. The put pays {40 - 0778035) = 12742 atthe lower node and rothing et the upper node since 1.16183(35) = 4.664 > 40. Using formula 202), s(t) ud ‘making the answer ‘The call pays off at tho upper node and only at the upper node. [ft didn’t pay of at all then would be 0. If it also patd off at the lower node, then Cy ~ Cy = S(1¢~ ) and = (C=Ge) om a= (GaGet a1 408 So equate the replicating portoio atthe lower node to: equate the replicating p 0.9(40)0.81873) + Bet = 0 =0.90(0.81879)e-0% = ~21.0276 490) ~ 21.0276 B ‘The call premium is AS + 20,30, Use equation (20.6), Statements () and (ji) were not needed. 2031. Since the forward price 602%") is greater than 80, the option does not pay off at the upper node. ‘Thus its price ise-* (60 ~ 804) ~ p"). By formula (20-7 for 1 = p" in a forward tee. 1 eM gga = 0-050 Wxtsady Mant etn ping ‘Cops eis AE2s 20_ BINOMIAL TREE: TOCK, ONE PERIOD 1.031250 = e-OMS 0.99125 2032, Let As be the number of shares of $ in the replicating portfolio and Ag the number of shares af Q in the replicating portfolio. Let B be the amount invested in a risk-free bond, The payotis ofthe portfolio, érom top to bottom, are 40,50, and 110. Then 90As +9043 + Bel = 40 Wis +100Ag + Be®® = 50 200d + Be ~ 120 Sabwact the second) equation from the first, and 704g = 10, so Ag Bel = 110~200/7 = 61.4286. Then plugging into the frst equation, ‘Then from the third equation, 30/7 ~ 81.4286 oF ace 0.58079 The option portfolios worth 50(=0.5079) + 10/7 + 81.4286" ‘Alternatively let pp, and p; be the risk-neutral probabilities of the three outcomes. Then 9p; +903 = Se => ph =1—Pi- PE 80p + 100p; +200(1 - Fe") = 100" => a0p% + 1009: 415961 Subtracting the first equation from 3 times the second equation, 2107, = 220" co9= 3.24047 au 2007 a gaes jp BI MOOED ss Tae option porto is worth +O (4(0 520985) 1 50(0.063055) 1 110(0.415961)) 20.33. Weeanreplicate Yby using X and abond, Let be the number of shares of Xto buy and the amount toiivestinatond. Then dec, 5080.8) py BEEP) pePFONS = 309) Subtracting the second equation frm the first, 2000"! = 40 3 = 2° = 1.98010 be® ®t = 79 20(-2) - 130 Then ¥(0) = 40a +} = 40(~1.98010) + 1300"%** =| Copegieeaisa(QUIZ SOLUTIONS FOR LESSON 20 283 The exercise can leo be done with isleneutral probabiltios. Let p* be the probability of Outcome 1, which corresponds to 1 in our formulas. By formula (20.3), soe 50 _ 4029-50 30-50 =a 436091 so the price of Yis .e-P5" (9.459091 (70) + (1 - 0.439091 (30) = -0™(47.5636) ~ [45.70] 2034. We con either wse a replicating portfolio or riskeneutral probabibitios. Replicating Portfolio Let Ay and Ay be the number of shares of X and Y respectively in the replicating portfolio, and B theamouat lent. Then the three outcomes imply 2004 + Bel = 98 ~ 108 50dy + Be" = 95, B0Ay + Bel = 0 Subtracting (+) from (0), 150A = -105, so Ay = ~0.7 and Be? ‘Ay = 713/30. Then Py = Cx = 100(dx + Ar) + B= 100(-07~ 13/30) +1306 10 190. From (+9), 300d + 130 a Risk Neutral Probabilities Letpbe the risk-neutral probability of outcome, For, we have 300p; = 1006", 50 75 ~ #3 = 0.368390. For X, we have 2005 = 5p = 100 200p4 + 50(4 - pj — €°"/3) = 1000 so p= 1 0.520244 ~ 0.398390 Quiz Solutions 120-1. Now the payoffs 10 the price goes down to 40,0 ifthe price goes up to 60. We therefore multiply the ‘scounted value of 10 times the probability of 40, or (0,1) ~ <°¥9( (06281840) + 0 -062818)00) 20-2. Now thorange of ening stock prices ssl 2b he aifference between the corresponding pat pot Gand 10,4810, $0 4= $e = 0. Then we solve for Bs eon + 8B = 0 30428 = 0 B= 300-0" = 28.5360 ‘The put prominsm is then ~0.5(50) + 28.5368 = 3.5369, the same as in the solution to Quiz 20-1 etsy Maen ation ping pep caw aneet 20, BINOMIAL TREES—STOCK, ONE PERIOD 2s, 1, The diference between high node and low node siock price is still 20 and we still need e-®! shares t0 cond up with 1 share at the end. The put is worth 0 ifthe stock price i 60 and 18 if itis 40, ora difference of 15. $04 =—Ber™® = -0173515. We solve for B: A(qoyeO2 + BO (-0.73815}60)e" + Be°% B = (0.73515)(60}e-O = 42,80500 ‘The put premiim is -0.7391550) + 42.8055 2. By putcall parity, as, 1) = P{S, 55,1) = Se? — Ket 2.7402 — (GS, 1) ~ 50e-*2 ~ 55-018 = 49.0099 — 92.3176 = -3.3077 7402+33077 204. Thelesst value is SeMO-2 = 43. 35¢09008 = 43954002 — [433] P(S,55,1) Copyegn cana NS