Comm 477 Assignment, due date: Nov.

22, 2017

INSTRUCTIONS:

Please work on this assignment individually and submit a hard copy in class on
Nov. 22, 2017.

You may discuss part of this assignment with other classmates but the final submission should
be your own individual work.

Be clear and tidy in your answers. Partial credit will be given for showing logically correct
reasoning.

1. [10 points] Assume the delta of a call on a stock is 0.6, the gamma of the call is 0.2 and you
have bought 100 such calls. Suppose the gamma on a put on the same stock is 0.2. The delta
of the put is -0.25. How can you construct a portfolio containing these calls to have zero delta
and zero gamma?

2. [10 points] Find the quote of 5 calls or put options with the same maturity, (T ) but
different strike price (K) written on an asset of your choice (e.g. a stock, a stock index,
a currency etc.). Compute the implied volatilty of each option by uysing the Black-Scholes
model. Plot on a graph the implied volatilty you obtained as a function of the moneyness
of the option, that is the distance of the strike price K from the current asset price S0 . What
do you observe? Try to give an interpretation of your results.

3. Spotting arbitrages
[15 points] You can buy or sell the following default-free bonds. All bonds mature at Year 3.
Their prices today and cash flows at the end of each year are the following:
Bond Price CF Year 1 CF Year 2 CF Year 3
A 94 4 4 104
B 100 6 6 106
C 112 12 12 112
Show that these prices allow an arbitrage opportunity and describe the investment strategy
that will allow you to exploit it.

4. Put Call Parity

(a) [10 points] The continuously-compounded risk free rate per annum is 20% per year.
European call options on the stock of XYZ CORP with an exercise price of $35 and
a maturity date 6 months hence are selling for $4. XYZ CORP will pay no dividends
during the next half year.
European put options with the same maturity date and exercise price are selling for
$0.67.
Short-sales of stock are strictly illegal. Use a payoff table to show how you can replicate
the payoff in 6 months time from short-selling 5 shares today.

1
 (b) [5 points] Suppose the stock of XYZ CORP is presently selling for $32. Use a payoff
table to show how you can make an arbitrage profit. You can buy XYZs stock.
(c) [10 points] Now suppose you cannot trade in the stock of XYZ CORP at all, but you
can still trade in options. Suppose European put and call options on XYZ CORP stock
with a maturity date 6 months hence and an exercise price of $45 are selling for $7 and
$1.50 respectively. Also assume that you can trade in the options in part (a).
Use the put call parity relationship and a payoff table to illustrate an arbitrage strategy
which will put money in your pocket today and will have zero payoffs in all future states
of the world.
5. Multi-Period Binomial Option Pricing
Note: This problems is calculation intensive. Consider using a spreadsheet.
Consider an American call. S0 = 40, X = 45, = 30% per year, er1 = 1.05 per year, T = 4
months = 13 year. The stock will pay no dividends over the four month life of the option.
The changes in the stocks price can be approximated by a series of up and down movements
and let there be 5 such movements over the 4 month life of the option; i.e., divide the four
months into 5 periods. Let n = 5. The length of each interval is then T /n = 1/3 = 1 year.
5 151 2 
T
n 15
Now we need a u and a d: the best place to get them is from . Let u = e =e ,
and d = u1 .

(a) [5 points] Assuming a totally flat riskless term structure, what is the gross return on a
1
riskless security over each of the intervals of length 15 of a year?
(b) [10 points] For each possible stock price and remaining time to maturity (i.e., at each
node in the tree of stock prices), calculate and B (i.e., the components of the repli-
cating portfolio) and the value of the call.
(c) [10 points] Suppose the stock first declines in value and then increases during each of
the remaining four periods. Use a table to show at each node the value of your stock and
bond portfolio both before and after any trading in stock and borrowing/repayment
of debt. Show explicitly how your stock purchases are financed by additional borrowing
and how the proceeds of any stock sales are used to repay borrowing.

6. Valuation and Replication of Puts

Note: This problems is calculation intensive. Consider using a spreadsheet.
A stock is now selling for $100. Each month it will either increase or decrease in value by
10% (u = 1.1, d = 0.9). The riskless rate with annual compounding is 12.682503% per year.
Note that 1.12682503 = 1.0112 . A European put option on this stock with an exercise price
of $105 matures in three months (n = 3).

(a) [5 points] Draw the tree of values for the stock price.
(b) [10 points] For each stock price and time to maturity (i.e., at all nodes of the tree),
determine the value of the European put.
(c) [10 points] Assume that the put option is American (exercise price $105 and maturity in
three months). Determine the value of this put for each stock price and time to maturity.
When (at which tree nodes) would it be optimal to exercise this put option?

2
7. Black-Scholes
Consider a European call. S0 = 40, X = 45, = 30% per year, er1 = 1.05 per year, T = 4
months = 31 year. The stock will pay no dividends over the four month life of the option.
Suppose that the stock prices follows a geometric Brownian motion. Continue to assume that
the annual standard deviation of the continuously compounded return on the stock is 30%.

(a) [5 points] Instead of approximating the stock price process as a binomial tree, use the
Black-Scholes model to value the call.
(b) [10 points] Now suppose that the changes in the stocks price can be approximated by a
series of up and down movements and let there be 5 such movements over the 4 month
life of the option; i.e., divide the four months into 5 periods.
q
Let
hq
n = 5.i The length
T 1
2
of each interval is then T /n = 1/3 1
5 = 15 year. Let u = e
n = e 15
, and d = u1 .
Compare the Black-Scholes value of the call to the value obtained from the Binomial
approximation.
(c) [5 points] What positions in stock and bonds should be taken today if the options payoff
at maturity is to be replicated through a dynamic strategy of trading in stock and bonds?
(d) [5 points] Use the put-call parity relationship for European options to determine the
value of a European put option on the stock with an exercise of $45 and a maturity date
four months hence.