FINANCIAL DERIVATIVES: FIN 430

Additional Problems and Solutions

Problem 12.5.
A stock price is currently $100. Over each of the next two six-month periods it is expected to
go up by 10% or down by 10%. The risk-free interest rate is 8% per annum with continuous
compounding. What is the value of a one-year European call option with a strike price of
$100?

In this case u 110 , d 090 , t 05 , and r 008 , so that

e00805 090
p 07041
110 090
The tree for stock price movements is shown in Figure S12.1. We can work back from the
end of the tree to the beginning, as indicated in the diagram, to give the value of the option as
$9.61. The option value can also be calculated directly from equation (12.10):
[070412 21 2 07041 02959 0 029592 0]e200805 961
or $9.61.

121
110 21

100 14.2063 99
9.6104
9 0
0 81
0
0

Figure S12.1 Tree for Problem

12.5

Problem 12.6.
For the situation considered in Problem 12.5, what is the value of a one-year European put
option with a strike price of $100? Verify that the European call and European put prices
satisfy putcall parity.

Figure S12.2 shows how we can value the put option using the same tree as in Problem 12.5.
The value of the option is $1.92. The option value can also be calculated directly from
equation (12.10):
e200805[070412 0 2 07041 02959 1 029592 19] 192
or $1.92. The stock price plus the put price is 100 192 $10192 . The present value of the
strike price plus the call price is 100e0081 961 $10192 . These are the same, verifying
that putcall parity holds.

121
110 0

100 99
1.9203 0.2843 1
90
81
6.078
19
1
Figure S12.2 Tree for Problem 12.6

Problem 12.19.
A stock price is currently $30. During each two-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 ST 0)]2 where ST is
the stock price in four months? If the derivative is American-style, should it be exercised
early?

This type of option is known as a power option. A tree describing the behavior of the stock
price is shown in Figure S12.6. The risk-neutral probability of an up move, p , is given by
e005212 09
p 06020
108 09
Calculating the expected payoff and discounting, we obtain the value of the option as
[07056 2 06020 03980 3249 039802 ]e005412 5394
The value of the European option is 5.394. This can also be calculated by working back
through the tree as shown in Figure S12.6. The second number at each node is the value of
the European option. Early exercise at node C would give 9.0 which is less than 13.2449.
The option should therefore not be exercised early if it is American.
 32.400 34.922
0.2785 D 0.000

B 29.160
30.000
5.3940 A 0.7056
E
C
27.000 24.300
13.2449 32.49
F

Figure S12.6 Tree to evaluate European power option in Problem 12.19. At each node, upper
number is the stock price and the next number is the option price

Problem 14.3.
Explain the principle of risk-neutral valuation.

The price of an option or other derivative when expressed in terms of the price of the
underlying stock is independent of risk preferences. Options therefore have the same value in
a risk-neutral world as they do in the real world. We may therefore assume that the world is
risk neutral for the purposes of valuing options. This simplifies the analysis. In a risk-neutral
world all securities have an expected return equal to risk-free interest rate. Also, in a risk-
neutral world, the appropriate discount rate to use for expected future cash flows is the risk-
free interest rate.

Problem 14.29.
Consider an option on a non-dividend-paying stock when the stock price is $30, the exercise
price is $29, the risk-free interest rate is 5% per annum, the volatility is 25% per annum, and
the time to maturity is four months.
a. What is the price of the option if it is a European call?
b. What is the price of the option if it is an American call?
c. What is the price of the option if it is a European put?
d. Verify that putcall parity holds.

In this case S0 30 , K 29 , r 005 , 025 and T 4 12

ln(30 29) (005 0252 2) 4 12
d1 04225
025 03333

ln(30 29) (005 0252 2) 4 12

d2 02782
025 03333

N (04225) 06637 N (02782) 06096

N (04225) 03363 N (02782) 03904

a. The European call price is

 30 06637 29e005412 06096 252
or $2.52.
b. The American call price is the same as the European call price. It is $2.52.
c. The European put price is
29e005412 03904 30 03363 105
or $1.05.
d. Put-call parity states that:
p S c KerT
In this case c 252 , S0 30 , K 29 , p 105 and e rT 09835 and it is easy to
verify that the relationship is satisfied,

Problem 18.25.
A financial institution has the following portfolio of over-the-counter options on sterling:

Type Position Delta of Option Gamma of Option Vega of Option

Call 1,000 0.5 2.2 1.8
Call 500 0.8 0.6 0.2
Put 2,000 -0.40 1.3 0.7
Call 500 0.70 1.8 1.4

A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.
(a) What position in the traded option and in sterling would make the portfolio both gamma
neutral and delta neutral?
(b) What position in the traded option and in sterling would make the portfolio both vega
neutral and delta neutral?

The delta of the portfolio is

1 000 050 500 080 2 000 (040) 500 070 450
The gamma of the portfolio is
1 000 22 500 06 2 000 13 500 18 6 000
The vega of the portfolio is
1 000 18 500 02 2 000 07 500 14 4 000

(a) A long position in 4,000 traded options will give a gamma-neutral portfolio since the long
position has a gamma of 4 000 15 6 000 . The delta of the whole portfolio
(including traded options) is then:
4 000 06 450 1 950
Hence, in addition to the 4,000 traded options, a short position of 1,950 in sterling is
necessary so that the portfolio is both gamma and delta neutral.
(b) A long position in 5,000 traded options will give a vega-neutral portfolio since the long
position has a vega of 5 000 08 4 000 . The delta of the whole portfolio (including
traded options) is then
5 000 06 450 2 550
Hence, in addition to the 5,000 traded options, a short position of 2,550 in sterling is
necessary so that the portfolio is both vega and delta neutral.

Problem 18.26.
Consider again the situation in Problem 18.25. Suppose that a second traded option with a
delta of 0.1, a gamma of 0.5, and a vega of 0.6 is available. How could the portfolio be made
delta, gamma, and vega neutral?

Let w1 be the position in the first traded option and w2 be the position in the second traded
option. We require:
6 000 15w1 05w2

4 000 08w1 06w2

The solution to these equations can easily be seen to be w1 3 200 , w2 2 400 . The whole
portfolio then has a delta of
450 3 200 06 2 400 01 1 710

Therefore the portfolio can be made delta, gamma and vega neutral by taking a long position
in 3,200 of the first traded option, a long position in 2,400 of the second traded option and a
short position of 1,710 in sterling.