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FINS2624 Problem Set 10 Solutions

This document provides solutions to 10 questions from a problem set on option pricing and hedging. Key points summarized: 1) It calculates the payoffs of a European call option under two stock price scenarios and finds the hedge ratio to create a riskless portfolio is 0.5556 shares of stock. 2) It then uses this to calculate the price of the option today, the price of the option at expiration, and implies the cost of the option today. 3) Several other questions calculate stock and option prices today using risk-neutral probabilities, expected stock prices, and implied interest rates to be consistent with no-arbitrage. 4) The last two questions calculate hedge ratios and prices

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26 views5 pages

FINS2624 Problem Set 10 Solutions

This document provides solutions to 10 questions from a problem set on option pricing and hedging. Key points summarized: 1) It calculates the payoffs of a European call option under two stock price scenarios and finds the hedge ratio to create a riskless portfolio is 0.5556 shares of stock. 2) It then uses this to calculate the price of the option today, the price of the option at expiration, and implies the cost of the option today. 3) Several other questions calculate stock and option prices today using risk-neutral probabilities, expected stock prices, and implied interest rates to be consistent with no-arbitrage. 4) The last two questions calculate hedge ratios and prices

Uploaded by

sdfklmjsdlklskfjd
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

FINS2624

PROBLEM SET 10 SOLUTION


Question 1.

a)

Using the notation introduced in the lecture, we have:


U = 1.25
D = 0.8
S0 = 100

Therefore,

uS0 = $100 x 1.25 = $125 = STu

S0

dS0 = $100 x 0.8 = $80 = STd

b)

The payoff of a European call option is:

= max( , 0)

Now,

= ,

Hence, if the market goes up, then:

= max( , 0) = max($125 $100,0) = $25

If the market goes down, then:

= max , 0 = max($80 $100,0) = $0


c)

We want to hold units of stock such that:

max( , 0) = max , 0

$125 $25 = $80

25
= 0.5556
125 80

d)

Substituting = 0.5556 into either $80 or $125 $25 gives us:

= $44.444

e)

0 = = $44.444 0.055 $42.07

f)

At time T, we know that

This implies that at time 0,

0 = 0 0

0 = 0 0
0 = 0.5556 $100 $42.07
0 = $13.49
g)

0.055 0.8
= 0.57
1.25 0.8

h)

( ) = 0.57 $125 + (1 0.57) $80 = $105.65

i)

Want to find rs such that:

0 = ( )

( )
= log 0.055
100

j)

( ) = 0.57 $25 + (1 0.57) $0 = $14.25

k)

Want to find rC such that:

0 = ( )

( )
= log 0.055
0
End of Chapter Questions

BKM Chapter 21

7.
Exercise Hedge
Price Ratio
120 0/30 = 0.000
110 10/30 = 0.333
100 20/30 = 0.667
90 30/30 = 1.000
As the option becomes more in the money, the hedge ratio increases to a maximum of
1.0.

9. a. uS 0 = 130 Pu = 0
dS 0 = 80 Pd = 30
Pu Pd 0 30 3
The hedge ratio is: H = = =
uS0 dS0 130 80 5

b.
Riskless
ST = 80 ST = 130
Portfolio
Buy 3 shares 240 390
Buy 5 puts 150 0
Total 390 390
Present value = $390/1.10 = $354.545

c. The portfolio cost is: 3S + 5P = 300 + 5P


The value of the portfolio is: $354.545
Therefore: 300 + 5P = $354.545 P = $54.545/5 = $10.91
Cu Cd 20 0 2
10. =
The hedge ratio for the call is: H = =
uS0 dS0 130 80 5
Riskless
S = 80 S = 130
Portfolio
Buy 2 shares 160 260
Write 5 calls 0 -100
Total 160 160
Present value = $160/1.10 = $145.455
The portfolio cost is: 2S 5C = $200 5C
The value of the portfolio is $145.455
Therefore: C = $54.545/5 = $10.91
Does P = C + PV(X) S?
10.91 = 10.91 + 110/1.10 100 = 10.91

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