Tutorial 3 Chapters 11 and 13 Hull 7 - Edition: B. B. Chakrabarti

Tutorial 3
Chapters 11 and 13
Hull 7
th
. Edition
B. B. Chakrabarti
Professor of Finance
B. B. Chakrabarti: bbc@iimcal.ac.in
2
Problem No. 11.8 (Hull 7th Ed.)
Consider the situation in which stock price
movements during the life of a European
option are governed by a two-step
binomial tree. Explain why it is not
possible to set up a position in the stock
and the option that remains riskless for
the whole of the life of the option.
3
Problem No. 11.8 (Ans.)
The riskless portfolio consists of a short
position in the option and a long position
in shares. Since changes during the
life of the option, this riskless portfolio
must also change.
4
A stock price is currently $50. It is known
that at the end of six months it will be
either $60 or $42. The risk-free rate of
interest with continuous compounding is
12% per annum. Calculate the value of a
six-month European call option on the
stock with an exercise price of $48. Verify
that no-arbitrage arguments and risk-
neutral valuation arguments give the same
answers.
5
The value of the six-month European call
option = 6.96
6
Problem No. 11.16 (Explanation)
At the end of six months the value of the option will be
either $12 (if the stock price is $60) or $0 (if the stock
price is $42).
Consider the portfolio consisting of :
+ : shares
1 : option
The value of the portfolio is either 42 or (60 12) in
six months.
If 42 = 60 12, then
= 0.6667
The value of the portfolio is 28.
For this value of this portfolio is therefore riskless.
7
Problem No. 11.16 (Explanation
contd.)
The current value of the portfolio is:
0.6667*50 f
Where f is the value of the option.
Since the portfolio must earn the risk-free
rate of interest
(0.6667*50 f)e
0.12*0.5
= 28
or, f = 6.96
8
Risk-neutral Valuation)
Suppose that p is the probability of an upward
stock price movement in a risk neutral world.
We must have,
60*p + 42*(1 p) = 50*e
0.06
or, p = 11.09
The expected value of option in a risk-neutral
world is:
12*0.6161 + 0*0.3839c = 7.3932
This has present value of 7.3932e
0.06
= 6.96
9
Problem No. 11.17A (Hull 7th Ed.)
A stock price is currently $40. Over each
of the next two three-month periods it is
expected to go up by 10% or down by 10%.
The risk-free interest rate is 12% per
annum with continuous compounding.
What is the value of a six-month European
put option with a strike price of $42?
10
Problem No. 11.17A (Ans.)
The value of a six-month European put
option = 2.118
11
Problem No. 11.17A (Explanation)
The risk-neutral probability of an up move, p, is given by
p = (e
0.25*0.12
0.9)/(1.1 0.9) = 0.6523
Calculating the expected payoff and discounting, we get
the value of the option as
= (2.4*2*0.6523*0.3477 + 9.6*0.3477
2
)*e
0.12*0.5
= 2.118
40
2.118
44
36
48.4
0.0
39.6
2.4
32.4
9.6
0.810
4.759
A
B
C
D
E
F
12
Problem No. 11.17B (Hull 7th Ed.)
A stock price is currently $40. Over each
of the next two three-month periods it is
expected to go up by 10% or down by 10%.
The risk-free interest rate is 12% per
annum with continuous compounding.
What is the value of a six-month American
put option with a strike price of $42?
13
Problem No. 11.17B (Ans.)
The value of the American put option =
2.537
14
Problem No. 11.17B (Explanation)
The value of the American put option is shown in
the tree diagram below.
40
2.537
44
36
48.4
0.0
39.6
2.4
32.4
9.6
0.810
Max (4.759, 6)
A
B
C
D
E
F
15
A stock price is currently $30. During each
2-month period for the next four months it
is expected to increase by 8% or reduce by
10%. The risk-free interest rate is 5%. Use
a two-step tree to calculate the value of a
derivative that pays off max[(30 S
T
), 0]
2
,
where S
T
is the stock price in 4 months? If
the derivative is American-style, should it
be exercised early?
16
Value of the European Style derivative =
5.394
Value of the American Style derivative =
5.394. Should not be exercised early.
17
European)
The risk-neutral probability of an up move, p, is given by
p = (e
0.05*(2/12)
0.9)/(1.08 0.9) = 0.6020
Calculating the expected payoff and discounting, we get the value of
the option as
= (0.7056*2*0.6020*0.3980+ 32.49*0.3980
2
)*e
0.5*(4/12)
= 5.394
30
5.394
32.4
27
34.922
0.0
29.160
0.7056
24.3
32.49
0.2785
13.2449
A
B
C
D
E
F
18
American)
30
5.394
32.4
27
34.922
0.0
29.160
0.7056
24.3
32.49
0.2785
Max (9, 13.2449)
A
B
C
D
E
F
19
Problem No. 13.9 (Hull 7
th
Ed.)

T 1.96 ) 2 /
2
- (
e
0
S and
T 1.96 - ) 2 /
2
- (
e
0
S
between is
T
S for interval confidence 95% a that prove
chapter, in this notation the Using
o o o o + T T
20
( ) ( )
( ) ( ) T T T T S
T T T T S
T
T
T
e S e
e S e
S
T T S T T S
S
T T S S
o o o o
o o o o
o
o
o
o
o
o
|
96 . 1 2 /
0
96 . 1 2 / ln
96 . 1 2 /
0
96 . 1 2 / ln
2
0
2
0
2
0
2 2
0
2 2
0
and
therefore are for intervals confidence 95%
96 . 1
2
ln and 96 . 1
2
ln
therefore are ln for intervals confidence 95%
,
2
ln ln
: know We
+ + +
+
=
=
+
|
|
.
|
\
|
+
|
|
.
|
\
|
+
(
|
|
.
|
\
|
+ ~
21
th
Ed.)
y. volatilit price stock the is and rate interest free risk the is r where
t) - (T 1)] - r(n 1) - n(n
2
[0.5
e T) h(t, that Show (c)
? T) h(t, for equation al differenti for the condition boundary the is What (b)
T). h(t, by satisfied equation al differenti ordinary
an derive equation, al differenti partial BSM in the ng substituti By (a)
T. and t of only function a is h and t at time price stock the is S where
n
S T) h(t,
form, the has T) (t t at time price its shown that be can it motion, Brownian
geometric follows price stock When the me. at that ti price stock the
is
T
S where T, at time
n
T
S off pays that derivative a Consider
o
o +
=
<
22
1 T) , h(T therefore is
equation al differenti for this condition boundary The
T. when t
n
S worth is derivative The
: b Part
rh ) 1 hn(n
2
2
1
rhn
t
h
obtain e equation w al differenti Scholes - Black the into ng Substituti
t h/
t
h where,
2 n
S ) 1 hn(n
2
S G/
2
and
,
1 n
hnS S G/ ,
n
S
t
h t G/ then
n
T)S h(t, t) G(S, If
: a Part
=
=
= + +
c c =
= c c
= c c = c c =
o
23
Problem No. 13.12 (Ans. contd.)
| |
constant. a is k where
k t n(n r(n ln(h)
is this to solution The
n(n r(n
h
h
written be can equation al differenti The
directly . a' Part ' in equation al differenti the solv e can we ely Alternativ
a'. Part ' in equation al differenti the satisfies it that shown be also can It
T. t when h to collapses it since condition boundary the satisfies
T) h(t, equation The
: c Part
t
t) (T ) r (n ) n(n
+
(
=
=
= =
=
+
) 1
2
1
) 1
) 1
2
1
) 1
, 1
2
2
1 1 5 . 0
2
o
o
o
e
24
| | t) (T r (n n(n
e T) h(t,
Hence,
t) (T n(n r(n ln(h)
that, So
T n(n r(n k
that follows it T t when 0 ln(h) Since
contd. : c Part
+
=
+ =
(
+ =
= =
) 1 ) 1 5 . 0
2
2
2
) 1
2
1
) 1
) 1
2
1
) 1
o
o
o
25
th
Ed.)
What is the price of a European put option
on a non-dividend-paying stock when the
stock price is $69, the strike price is $70,
the risk-free interest rate is 5% per annum,
the volatility is 35% per annum, and the
time to maturity is six months?
26
The price of this European put option
= 6.40
27
Problem No. 13.14 (Explanation)
40 . 6
4338 . 0 * 69 5323 . 0 * 70
) 1666 . 0 ( 69 ) 0809 . 0 ( 70
0809 . 0 5 . 0 35 . 0
1666 . 0
5 . 0 35 . 0
5 . 0 ) 2 / 35 . 0 05 . 0 ( ) 70 / 69 (
5 . 0 * 05 . 0
5 . 0 * 05 . 0
1 2
2
1
=
=

= =
=
- + +
=
= = = = =
e
N N e
is put European the of price The
d d
ln
d
0.5 T and 0.35 0.05, r 7 0, K 69, S
case, this In
0
o
28
th
Ed.)
Consider an American call option on a stock. The
stock price is $70, the time to maturity is eight
months, the risk-free rate of interest is 10% per
annum, the exercise price is $65, and the
volatility is 32%. A dividend of $1 is expected
after three months and again after six months.
Show that it can never be optimal to exercise the
option on either of the two dividend dates.
29
early . option call the exercise to optimal nev er is It
) K(1 D and ) K(1 D
Since
1 .60 ) 65(1 ) K(1 and
1 .07 ) 65(1 ) K(1 1 , D D
slide, this of notation the Using
) t r (t
2
) t r (T
1
0.25 * 0.1 ) t r (t
0.1667 * 0.1 ) t r (T
2 1
1 2 2
1 2
2

< <
= =
= = = =
e e
e e
e e
30
th
Ed.)
c c c c
1 2
1 2
1 2
-r(T-t)
With the notation used in this chapter
a. What is N'(x)?
b. Show that SN'(d ) = Ke N'(d ), where S is the stock price at time t and
d and d are common notations.
c. Calculate d / S and d / S.
d.
c o
=
c
c c
1 2
2 1
1
-r(T-t)
-r(T-t)
Show that, when c = SN(d ) - Ke N(d ),
c
it follows that rKe N(d ) SN'(d )
t
2 T-t
where c is the price of a call option on a non-dividend-paying stock.
e. Show that c/ S =N(d ).
f. Show tha
t c satisfies the Black-Scholes differential equation.

g. Show that c satisfies the boundary condition for a European call option, i.e., that
c = max(S - K, 0) as t T.
31
| | | |
| | ) ( ) / ln( ) (
2
1
/ ) ( ) / ln( * 2
) )( 2 /
2
( ) / ln( ) )( 2 /
2
( ) / ln(
2
1
) ( '
) ( '
) (
2
1
2
2
1 2 1 2
2 1
2
2
t T r K S d d
t T t T r K S d d t T d d
t T
t T r K S
d
t T
t T r K S
d
e N
N
N
x
+ =
+ = + =

+
=
+ +
=
=

o o
o
o
o
o
t
; Hence,
; Now,
: b Part
x is, that
on, distributi normal ed standardiz a for function density y probabilit
the is x x, than less be will on distributi normal ed standardiz
a with v ariable a that y probabilit cumulativ e the is x Since
: a Part
32
then if know we as
Hence,
; Again
: c Part
Finally ,
Now,
-contd. : b Part
x x
y
x y
t T S
S
d
t T S
S
d
t T
t T r K S
d
t T
t T r K S
d
d N Ke d SN
e S K e e
d N
d N
t T r
t T r t T r S K
d d
1
, ln
1
;
1
) )( 2 /
2
( ln ln ) )( 2 /
2
( ln ln
) ( ' ) ( '
) / (
) ( '
) ( '
2 1
2 1
2
) (
1
) ( ) ( ) / ln(
) (
2
1
2
1
2
1
2
2
=
c
c
=

=
c
c
=
c
c

+
=
+ +
=
=
= = =

o o
o
o
o
o
33
| |
t T
d SN d N rKe
t
c
t T
t T
t t
d
t
d
t T d d
t
d
t
d
d SN d N rKe
t
c
d N Ke d SN
t
d
d N Ke d N rKe
t
d
d SN
t
c
d N Ke d SN c
t T r
t T r
t T r
t T r t T r
t T r

+ =
c
c

=
c
c
=
c
c
c
c
=
(
c
c
c
c
+ =
c
c
=
c
c

c
c
=
c
c
=

2
) ( ' ) (
2
) ( ' ) (
) ( ' ) ( '
) ( ' ) ( ) ( '
) ( ) (
1 2
) (
2 1
2 1
2 1
1 2
) (
2
) (
1
2
2
) (
2
) (
1
1
2
) (
1
o
o
o o ; Again,
But,
Giv en
: d Part
34
t T S
d N
S
d
d N
S
c
d N
S
c
S
d
d N Ke
S
d
d SN d N
S
c
t T r
=
c
c
=
c
c
=
c
c
c
c
c
c
+ =
c
c

o
1
) ( ' ) ( '
) (
) ( ' ) ( ' ) (
1
1
1
2
2
1
2
2
) (
1
1 1
obtain we
, c' Part ' in result the using and e' Part ' in result the ating Differenti
: f Part
that follows it
c' Part ' and b' Part ' in results the From
obtain we
price, call a for formula Scholes - Black the ating differenti From
: e Part
35
| |
equation. al differenti Scholes - Black e satisfy th indeed does
option call a for formula Scholes - Black that the shows The

) ( ) (
) ( '
2
1
) (
2
) ( ' ) (
2
1
e' Part ' and d' Part ' results the From
-contd. : f Part
2
) (
1
1
2 2
1
1 2
) (
2
2
2 2
rc
d N Ke d SN r
t T S
d N S d rSN
t T
d SN d N rKe
s
c
S
S
c
rS
t
c
t T r
t T r
=
=

+ +

=
c
c
+
c
c
+
c
c

o
o
o
o
o
}
=
5
1 i
n
m
36
Part g
As t T, (T-t) 0, d1 and d2 , N(d1)
and N(d2) 1.
Hence, if the call is exercised,
value = S*1 k*e^(-r*0)*1 = S K.
The value will be zero, if the call is not
exercised.
Hence, c = max (S-K) as t T.

Tutorial 3 Chapters 11 and 13 Hull 7 - Edition: B. B. Chakrabarti

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Tutorial 3 Chapters 11 and 13 Hull 7 - Edition: B. B. Chakrabarti

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t c satisfies the Black-Scholes differential equation.

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