Mid-term

Total = 40 marks

Financial Derivatives

Date: 27th July 2007

Time = 1 hour 30 minutes

Note: This is an open book / open notes / open formula sheet exam students are
allowed to bring in the textbook (Hull), notes, the formula sheet and the normal
distribution table. But no exchange of notes / books /formula sheets / tables between the
students are allowed during the exam

1. What happens to the following:

a. A look back call as we increase the frequency with which we observe the
asset price in calculating the minimum
b. A down and out call as we increase the frequency with which we observe
the asset price in determining whether the barrier has been crossed
[3 + 3 = 6 marks]
2. Arithmetic average rate options were assumed to be newly issued, and there was
no historical average to deal with. Show that no generality was lost in doing so.
[5 marks]
3. Assume Binomial Option Pricing Model. Show that a contingent claim that pays
$1 when the stock prices reaches (S ui dn-I) and $0 otherwise can be replicated by
a portfolio of calls.
[5 marks]
4. Show that At the Money options have the maximum time value
[5 marks]
5. At what stock price is the theta of a European Call the smallest?
[5 marks]
W (t ) 2
6. Let {W(t); t 0} be a Brownian motion. Verify whether
is a martingale or
2
not.
[5 marks]
7. Consider a 9-month call option with an interest rate of 8% and n = 3 (i.e. there are
nodes at the 3 month time point, 6 months time point and the final one at the 9
month time point). The current volatility is 10% but the volatility changes
between each time point at the rate of 7%. Let the current spot price be $160 and
the strike price is $176. The option is of the American type. What is the premium
that is to be paid for this option?
Also, find the premium to be paid if the option was a put option with all the other
information remaining the same.
[5 + 4 = 9 marks]

Solutions
Solution to question 1:
a. As we increase the frequency, we observe a more extreme minimum, which
increases the value of a look back call.
b. As we increase the frequency with which the asset price is observed, the asset
price becomes more likely to hit the barrier and the value of a down and out call
goes down.

Solution to question 2:
Let the historical average from m prices be A as of time zero. The terminal payoff for a
call is then
n

mA
S
+

Si

i
mA

i =0
i =0

max
X
X , 0 = max
, 0
m + n +1

m + n + 1
m + n 1

n
Si

n +1
m + n +1
mA
i =0

=
max

X
, 0
n +1
m + n +1
n +1
m + n 1

So it becomes

n +1
m + n +1
mA
options with strike price
X
.
m + n +1
n +1
m + n 1

Solution to question 3:
Consider the butterfly spread with strike prices XL, XM and XH such that
Su i 1 d n i +1 < X L < Su i d n i
X M = Su i d n i
Su i d n i < X H < Su i +1 d n i 1
with 2 XM XH XL = 0. This portfolio pays off Su i d n i X L dollars when the stock
price reaches Su i d n i . Furthermore, its payoff is zero if the stock price finishes at other
prices.

Solution to question 4:
We have to prove that the strike price X that maximizes the options time value is the
current stock price S. Note that time value is defined as
V = C max(S X, 0).
Now,
C
= e rT N x T
X
V C

=
<0
if X > S
X X
V C
and
=
+1 > 0
if X > S
X X

Thus, the time value is maximized at S.

Solution to question 5:
It is as
2
(r +
)t
2

S = Xe

To derive it, note that

N ' ( x ) + SN '' ( x ) x '

=
rXe rt N ' ( x t ) x '
S
2 t
=

N ' ( x ) + SN '' ( x ) x '

2 t

rSN ' ( x ) x '

The last equality takes advantage of the fact that

Xe rt N ' ( x t ) x ' = SN ' ( x ) x '

And the Black Scholes formula for European call. With N(x) = -x N(x) and x =
1/(St), it is not hard to see that the particle derivative is 0 if and only iff
- 2 + (x/t) 2r = 0.
From here the result follows easily.

Solution to question 6:

W (t ) 2

E
| W (u ), 0 u s
2

W ( s ) 2

W (t ) 2 W ( s ) 2

= E
| W (u ), 0 u s + E

| W (u ), 0 u s
2
2

W (s) 2 t s
=
+
2
2
Thus it is not a martingale.