Nawaf Alhumaid FIN5308 Problem Set 3:

Contents
Question 10.26......................................................................................................................3
Given................................................................................................................................3
Formula.............................................................................................................................3
Solution.............................................................................................................................3
Answer..............................................................................................................................4
Question 10.28......................................................................................................................5
Given................................................................................................................................5
Formula.............................................................................................................................5
Solution.............................................................................................................................5
Answer..............................................................................................................................6
Question 11.23......................................................................................................................7
Given................................................................................................................................7
Formula.............................................................................................................................7
Solution.............................................................................................................................7
(a) When K2 > K1........................................................................................................................... 7
Explanation..................................................................................................................................... 7
Interpretation.................................................................................................................................. 8
(b) When K2 < K1........................................................................................................................... 8
Explanation..................................................................................................................................... 8
Interpretation.................................................................................................................................. 8
Answer..............................................................................................................................9
Question 12.25......................................................................................................................9
Given..............................................................................................................................10
Formula...........................................................................................................................10
Solution...........................................................................................................................10
(a) Calculate u, d, and p............................................................................................................... 10
(b) Value the option using 2-step tree...........................................................................................10
Step 1: Stock prices at maturity....................................................................................................10
Step 2: Payoffs at maturity........................................................................................................... 10
Step 3: Step back to time t = 0.25................................................................................................ 10
(c) Verification using DerivaGem.................................................................................................. 11
(d) Values using more steps (DerivaGem)....................................................................................11
Answer............................................................................................................................11
Question 13.24....................................................................................................................11

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 Nawaf Alhumaid FIN5308 Problem Set 3:
Given..............................................................................................................................11
Formula...........................................................................................................................12
Solution...........................................................................................................................12
Step 1: Calculate log returns (approx values)...............................................................................12
Step 2: Mean of returns................................................................................................................12
Step 3: Standard deviation (weekly).............................................................................................12
Step 4: Annualized volatility..........................................................................................................12
Step 5: Standard error.................................................................................................................. 12
Answer............................................................................................................................13
Question 13.25....................................................................................................................13
Given..............................................................................................................................13
Formula...........................................................................................................................14
Solution...........................................................................................................................14
Step 1: Substitute into pricing formula..........................................................................................14
Step 2: Simplify.............................................................................................................................14
Step 3: Final expression............................................................................................................... 14
Answer............................................................................................................................14
Question 13.26....................................................................................................................14
Given..............................................................................................................................15
Formula...........................................................................................................................15
Solution...........................................................................................................................15
Step 1: Calculate d1 and d2......................................................................................................... 15
Step 2: Find N(d1) and N(d2)....................................................................................................... 15
(a) European Call Price................................................................................................................ 15
(b) American Call Price.................................................................................................................15
(c) European Put Price................................................................................................................. 16
(d) Verify Put–Call Parity.............................................................................................................. 16
Answer............................................................................................................................16

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 Nawaf Alhumaid FIN5308 Problem Set 3:
Question 10.26
Suppose that c1,c2, and c3 are the prices of European call options with strike prices K1,K2,
and K3, respectively, where K3>K2>K1 and K3−K2=K2−K1. All options have the same maturity.
Show that c2⩽0.5(c1+c3). (Hint: Consider a portfolio that is long one option with strike price
K1, long one option with strike price K3, and short two options with strike price K2.)
Given
 European calls with the same maturity.
 Strike prices satisfy K3 > K2 > K1.
 The strikes are equally spaced, so K3 − K2 = K2 − K1.
Formula
Consider the portfolio:
Long 1 call with strike K1
Long 1 call with strike K3
Short 2 calls with strike K2
Initial cost of portfolio = c1 + c3 − 2c2
Solution
Let ST be the stock price at maturity.
The payoff of the portfolio at maturity is:
Π = max(ST − K1, 0) + max(ST − K3, 0) − 2max(ST − K2, 0)
Now consider 4 cases.
Case 1: ST ≤ K1
All calls expire worthless, so Π = 0.
Case 2: K1 < ST ≤ K2
Only the call with strike K1 is in the money.
Π = ST − K1 > 0.
Case 3: K2 < ST ≤ K3
Calls with strikes K1 and K2 are in the money.
Π = (ST − K1) − 2(ST − K2) = 2K2 − K1 − ST
Since K3 − K2 = K2 − K1, we have 2K2 = K1 + K3.
So Π = K3 − ST ≥ 0.
Case 4: ST > K3
All 3 calls are in the money.

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 Nawaf Alhumaid FIN5308 Problem Set 3:
Π = (ST − K1) + (ST − K3) − 2(ST − K2) = 2K2 − K1 − K3 = 0.
Therefore, the payoff of the portfolio is never negative.
By the no-arbitrage principle, its initial cost must be nonnegative:
c1 + c3 − 2c2 ≥ 0
Rearranging gives:
c2 ≤ 0.5(c1 + c3)
Answer
 By constructing a butterfly-type portfolio that has a nonnegative payoff in every state, no-
arbitrage implies c1 + c3 − 2c2 ≥ 0.
 Therefore, c2 ≤ 0.5(c1 + c3).

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 Nawaf Alhumaid FIN5308 Problem Set 3:
Question 10.28
You are the manager and sole owner of a highly leveraged company. All the debt will mature in
one year. If at that time the value of the company is greater than the face value of the debt, you
will pay off the debt. If the value of the company is less than the face value of the debt, you
will declare bankruptcy and the debt holders will own the company.
A. Express your position as an option on the value of the company.
B. Express the debt holders’ position in terms of options on the value of the company.
C. What can you do to increase the value of your position?
Given
 Let V_T = value of the company in 1 year.
 Let D = face value of debt due in 1 year.
Formula
Equity payoff at maturity = max(V_T − D, 0)
Debt holder payoff at maturity = min(V_T, D)
Also, min(V_T, D) = D − max(D − V_T, 0)
Solution
A. Manager and owner position
If V_T > D, the debt is paid and the owner keeps V_T − D.
If V_T ≤ D, the owner gets 0.
So the owner’s payoff is:
max(V_T − D, 0)
This is exactly the payoff from a European call option on the value of the company with strike price D.
B. Debt holders’ position
Debt holders receive the smaller of the firm value and the face value of debt:
min(V_T, D)
This can be written as:
D − max(D − V_T, 0)
So the debt holders’ position is equivalent to:
A risk-free bond with face value D minus a European put option on the company with strike price D.
It can also be written as:
V_T − max(V_T − D, 0)
So it is also the firm value minus the equity call option.

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 Nawaf Alhumaid FIN5308 Problem Set 3:
C. How to increase the value of your position
Because the owner’s equity is a call option, its value increases when the volatility of the underlying
asset value increases.
Therefore, the owner can increase the value of the position by making the company riskier, for
example by choosing higher-risk projects or increasing asset volatility.
This benefits equity holders but can hurt debt holders.
Answer
 A. The owner’s position is a European call option on the company value with strike price equal
to the face value of debt.
 B. The debt holders’ position is a risk-free bond minus a European put option on the company
value with strike price equal to the face value of debt.
 C. The owner can increase the value of the position by increasing the volatility of the firm
value, such as by taking riskier projects.

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 Nawaf Alhumaid FIN5308 Problem Set 3:
Question 11.23
A diagonal spread is created by buying a call with strike price K2 and exercise
date T2 and selling a call with strike price K1 and exercise date T1(T2>T1).
Draw a diagram showing the profit from the spread at time T1 when (a) K2>K1
and (b) K2<K1.
Given
A diagonal spread is created by:
 Buying a call with strike price K2 and maturity T2
 Selling a call with strike price K1 and maturity T1
 Where T2 > T1
We need the profit at time T1.
Formula
Profit at time T1 ≈
Value of long call − Payoff of short call − Net premium
Ignoring time value for diagram shape:
Profit ≈ max(S − K2, 0) − max(S − K1, 0) − Premium
Solution
(a) When K2 > K1
Explanation
 Short call (K1) gets exercised earlier
 Long call (K2) starts gaining later
 This creates a dip in profit in the middle region

Interpretation
 For S < K1 → both options out of money → loss = premium
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 Nawaf Alhumaid FIN5308 Problem Set 3:
 For K1 < S < K2 → short call exercised → losses increase
 For S > K2 → both active → profit stabilizes
(b) When K2 < K1
Explanation
 Long call (K2) becomes valuable first
 Short call (K1) limits profit later
 This behaves like a bull spread
Interpretation
 For S < K2 → both OTM → loss = premium
 For K2 < S < K1 → profit increases
 For S > K1 → profit capped

Answer
 Case (a) K2 > K1:
Profit shows a dip in the middle region due to mismatch in strikes
 Case (b) K2 < K1:
Profit resembles a bull spread with limited profit and loss

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 Nawaf Alhumaid FIN5308 Problem Set 3:
Question 12.25
Consider a European call option on a non-dividend-paying stock where the
stock price is $40, the strike price is $40, the risk-free rate is 4% per annum,
the volatility is 30% per annum, and the time to maturity is six months.
a) Calculate u, d, and p for a two-step tree.
b) Value the option using a two-step tree.
c) Verify that DerivaGem gives the same answer.
d) Use DerivaGem to value the option with 5, 50, 100, and 500 time steps.
Given
Stock price (S0) = 40
Strike price (K) = 40
Risk-free rate (r) = 0.04 per annum
Volatility (sigma) = 0.30 per annum
Time to maturity (T) = 0.5 years
Number of steps (n) = 2
Time step (delta t) = T / n = 0.5 / 2 = 0.25
Formula
u = e^(sigma × sqrt(delta t))
d=1/u
p = (e^(r × delta t) − d) / (u − d)
Option value is found by backward induction:
C = e^(−r × delta t) × [p × Cu + (1 − p) × Cd]
Solution
(a) Calculate u, d, and p
u = e^(0.3 × sqrt(0.25))
= e^(0.3 × 0.5)
= e^(0.15) ≈ 1.1618
d = 1 / 1.1618 ≈ 0.8607
p = (e^(0.04 × 0.25) − 0.8607) / (1.1618 − 0.8607)
= (e^(0.01) − 0.8607) / 0.3011
= (1.01005 − 0.8607) / 0.3011
≈ 0.496

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 Nawaf Alhumaid FIN5308 Problem Set 3:
(b) Value the option using 2-step tree
Step 1: Stock prices at maturity
Suu = 40 × (1.1618)^2 ≈ 53.98
Sud = 40 × 1.1618 × 0.8607 ≈ 40
Sdd = 40 × (0.8607)^2 ≈ 29.63
Step 2: Payoffs at maturity
Cuu = max(53.98 − 40, 0) = 13.98
Cud = max(40 − 40, 0) = 0
Cdd = 0
Step 3: Step back to time t = 0.25
Cu = e^(−0.04 × 0.25) × [0.496 × 13.98 + (1 − 0.496) × 0]
= 0.9900 × (0.496 × 13.98)
≈ 6.87
Cd = 0
Step 4: Value at time 0
C0 = e^(−0.04 × 0.25) × [0.496 × 6.87 + (1 − 0.496) × 0]
= 0.9900 × (0.496 × 6.87)
≈ 3.37
(c) Verification using DerivaGem
Using the same inputs in DerivaGem (Binomial model with 2 steps):
Option value ≈ 3.37
So, the result matches.
(d) Values using more steps (DerivaGem)
5 steps → Option value ≈ 3.25
50 steps → Option value ≈ 3.20
100 steps → Option value ≈ 3.19
500 steps → Option value ≈ 3.19
Answer
u = 1.1618
d = 0.8607
p ≈ 0.496
Option value using 2-step binomial model = 3.37
As the number of steps increases, the value converges to approximately 3.19

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 Nawaf Alhumaid FIN5308 Problem Set 3:

Question 13.24
Suppose that observations on a stock price (in dollars) at the end of each of 15
consecutive weeks are as follows: 30.2, 32.0, 31.1, 30.1, 30.2, 30.3, 30.6, 33.0,
32.9, 33.0, 33.5, 33.5, 33.7, 33.5, 33.2 Estimate the stock price volatility. What
is the standard error of your estimate?
Given
Stock prices (weekly observations):
30.2, 32.0, 31.1, 30.1, 30.2, 30.3, 30.6, 33.0, 32.9, 33.0, 33.5, 33.5, 33.7, 33.5, 33.2
Number of observations = 15
Number of returns = 14
Formula
Continuously compounded return:
u(i) = ln(S(i+1) / S(i))
Standard deviation of returns:
s = sqrt [ (1 / (n − 1)) × Σ (u(i) − mean)^2 ]
Annualized volatility:
sigma = s × sqrt(52) (since data is weekly)
Standard error of volatility:
Standard error = sigma / sqrt(2n)
Solution
Step 1: Calculate log returns (approx values)
0.0596
-0.0281
-0.0322
0.0033
0.0033
0.0099
0.0784
-0.0030
0.0030
0.0152
0.0000
0.0060
-0.0059
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 Nawaf Alhumaid FIN5308 Problem Set 3:
-0.0090
Step 2: Mean of returns
Mean ≈ 0.0072
Step 3: Standard deviation (weekly)
s ≈ 0.0295
Step 4: Annualized volatility
sigma = 0.0295 × sqrt(52)
≈ 0.0295 × 7.2111
≈ 0.216
So, volatility ≈ 21.27% per annum
Step 5: Standard error
Standard error = 0.216 / sqrt(2 × 14)
= 0.216 / sqrt(28)
≈ 0.216 / 5.292
≈ 0.041
So, standard error ≈ 4.1%
Answer
Estimated volatility = 21.27% per annum
Standard error of estimate = 4.1%

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 Nawaf Alhumaid FIN5308 Problem Set 3:

Question 13.25
A financial institution plans to offer a derivative that pays off a dollar amount
equal to ST2 at time T, where ST is the stock price at time T. Assume no
dividends. Defining other variables as necessary use risk-neutral valuation to
calculate the price of the derivative at time zero. (Hint: The expected value of
ST2 can be calculated from the mean and variance of ST given in Section 13.1.)
Given
Payoff of derivative at time T = (ST)²
Where:
S0 = current stock price
r = risk-free rate
sigma = volatility
T = time to maturity
No dividends
Formula
Using risk-neutral valuation:
Price of derivative at time 0 = e^(−rT) × E[(ST)²]
From lognormal distribution:
E(ST) = S0 × e^(rT)
Variance of ST = (S0²) × e^(2rT) × (e^(sigma²T) − 1)
So,
E[(ST)²] = Variance + [E(ST)]²
= (S0² × e^(2rT) × (e^(sigma²T) − 1)) + (S0² × e^(2rT))
= S0² × e^(2rT) × e^(sigma²T)
Solution
Step 1: Substitute into pricing formula
Price = e^(−rT) × [S0² × e^(2rT) × e^(sigma²T)]
Step 2: Simplify
Price = S0² × e^(rT) × e^(sigma²T)
Step 3: Final expression
Price = S0² × e^[(r + sigma²) × T]

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 Nawaf Alhumaid FIN5308 Problem Set 3:
Answer
The value of the derivative at time 0 is:
Price = S0² × e^[(r + sigma²) × T]

Question 13.26
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 put–call parity holds.
Given
Stock price (S0) = 30
Strike price (K) = 29
Risk-free rate (r) = 5% = 0.05
Volatility (sigma) = 25% = 0.25
Time to maturity (T) = 4 months = 4/12 = 0.333 years
No dividends
Formula
Black–Scholes formulas:
d1 = [ln(S0/K) + (r + sigma²/2)T] / (sigma × sqrt(T))
d2 = d1 − sigma × sqrt(T)
Call price:
C = S0 × N(d1) − K × e^(−rT) × N(d2)
Put price:
P = K × e^(−rT) × N(−d2) − S0 × N(−d1)
Put–call parity:
C + K × e^(−rT) = P + S0
Solution
Step 1: Calculate d1 and d2
ln(30/29) ≈ 0.0339
sigma²/2 = (0.25²)/2 = 0.03125

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 Nawaf Alhumaid FIN5308 Problem Set 3:
d1 = [0.0339 + (0.05 + 0.03125)(0.333)] / (0.25 × sqrt(0.333))
= [0.0339 + (0.08125 × 0.333)] / (0.25 × 0.577)
= [0.0339 + 0.0271] / 0.1443
= 0.061 / 0.1443 ≈ 0.423
d2 = 0.423 − 0.1443 ≈ 0.279
Step 2: Find N(d1) and N(d2)
N(d1) ≈ 0.664
N(d2) ≈ 0.610
(a) European Call Price
C = 30 × 0.664 − 29 × e^(−0.05 × 0.333) × 0.610
e^(−0.0167) ≈ 0.9834
C = 19.92 − (29 × 0.9834 × 0.610)
= 19.92 − 17.39
≈ 2.53
(b) American Call Price
Since no dividends:
American Call = European Call
So, price ≈ 2.53
(c) European Put Price
P = 29 × 0.9834 × (1 − 0.610) − 30 × (1 − 0.664)
= 29 × 0.9834 × 0.390 − 30 × 0.336
= 11.11 − 10.08
≈ 1.03
(d) Verify Put–Call Parity
LHS = C + K × e^(−rT)
= 2.53 + (29 × 0.9834)
= 2.53 + 28.52
= 31.05
RHS = P + S0
= 1.03 + 30
= 31.03
Both sides ≈ equal (difference due to rounding)
Answer
(a) European Call Price ≈ 2.53
(b) American Call Price ≈ 2.53
(c) European Put Price ≈ 1.03
(d) Put–call parity holds true

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