Problem Set 5
Winston Dou Fall 2024
Due: 11/19/2024
Question 1: European and American Puts (3/10) You wish to price an European
put on a stock which currently trades for $100. The put expires in nine months, and has a
strike of $100. The nine-month interest rate (annualized continuously compounded) is 5%.
The estimated volatility of the stock is 25%. The stock pays no dividends.
(i) What is the Black-Scholes-Merton price of the European put?
(ii) What is the price of the European put according to a standard 3-step binomial tree?
(iii) Suppose the standard 3-step binomial tree is the true description of stock price
movements in the real world. If the European put is trading for $6, is there an
arbitrage? If not, explain why not. If so, explain in detail what your strategy is.
(iv) What is the price of the American put according to a 3-step binomial tree?
(v) Under what circumstances, if any, do you exercise the put before maturity?
Question 2: Binomial Option Pricing (3/10) A share in the company no dividends
(ND) currently trades at $80. The volatility of the stock price is 25% and the expected rate
of return is 12%; i.e. E[S1 ] = 80e0.12 . The continuously compounded risk-free rate is 3%.
Assume that the volatility, the expected rate of return, and the risk-free rate are constant.
(i) What is the price of an at the money European call and put option that matures in
one year?
Use the Excel macro on CANVAS to determine the price of the at money call for
di↵erent h = T /N . Specifically, consider three di↵erent cases for N : N = 5, N = 10,
and N = 100. Use put-call parity to determine the price of the put.
(ii) What is the price of an American at-the-money put that matures in one year?
(ii.a) Use the Excel macro on CANVAS to determine the price of the American put.
Choose N = 100.
1
(ii.b) Compare the price of the American put to the price of the European put. Explain
intuitively why somebody would like to exercise an American put early.
(iii) Show that it is never optimal to exercise a call on a non-dividend paying stock early
without making any assumptions about the movements of the stock.
Question 3: Implied Volatility and Put-Call Parity (2/10) .
Suppose S = 100 and there are both a 9-month European call and a 9-month European
put with K = 100. The continuously compounded risk-free rate is 5%, and there are no
payouts.
(i) The call currently trades at a price of 14.087. What is the Black-Scholes implied
volatility?
(ii) The put trades at an implied volatility of 36.85%. Is there an arbitrage opportunity
here? If so, how would you take advantage of it and what are the cash flows?
Question 4: Greeks for Black-Scholes-Merton Model (2/10) The strike price of a
European call option is $100 which is also the spot of the underlying asset. The continuously
compounded annualized interest rate is 10%. The annualized volatility of the stock return is
50%. The stock does not pay dividend. Today is t = 0 and the call expires at T = 1 year.
(i) What are the Delta ( ) and the Gamma ( ) of the European call option? You need
to show how to derive the formula.
(ii) What is the Vega of the European call option? You need to show how to derive the
formula.
2
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s 2
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Ss and 100 1 1333 1.1333 x 1 11762 113.33614
iii
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Painn o
Sound 113.3301
and
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sz.ua 7 P3 nad 100 88.24068 11.7593
ssay
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e
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si.za Pziua
518816 0 1.481184 0 0
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Pardd e
ios 25 1.481184 31.298
1 518816 11.7593 2089814
Pi a e
195 25
51881610 48118415.588097 2.6555
195 25
Pig e x 518816 5.588097 481184120.898141 12.79411
95 25
Po e 518816 2 6555 481184 12.7941131 744046
Yesthere is arbitrage as theput is undervalued
of 40 400 6
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sit.it t.in je aauo at
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mitrii ns.o.es
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05 25
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Max 0 7.721 7.726
Initied ask.vn a Éire payfe y I inavainganiamass.in the
example thishappens when S Saidd
3
N S 9 465 9.46St 809 p 8D p 7.101
N 10 8.884 8.884 8 e 03 P 8048 6.819
9.059 0311
100 a asa 809 P 80 p 6.695
call put
50 80 N 100 P 6.929
1180
P 6.929 6.69s PG because theamerican
option offers the flexibility of being ableto
exerciseearly You would exercise anamerican
put early if the immediate payout from
expectedfuture
exercising K S isgreater than the
benefits ofholding the put until T such as if
refinvest the
payout for a betterreturn
IT done 9h
c If you exercise a can before maturity you get s k
but if youdon't youget S K O T
in our no arbitrage bounds we know
ut max o s k
s k o e z max o s ke
so it's better to hold onto the call until maturity
chosen so call So k Tiv q Oimp
5 100 sur dis ke rit tin as
1 2.36
7 9 12 00
9519127
1002 1 normade 10000 04706 100 11 normidftnor _27707
96.31944 516775 100 39086 810.6896
a no
dz 27707 36855112 04206
05 9 12
14.087 100 e 10,689 100
110.406 110.689
there is asmallpotntial arbitrage
belarse 110.406 110 689
short the call option receive 14.087
receive 103.398 at a
buy the putoption down 10.689
shortstock
If 5,3100
you get 57 100 set 100 St
at time t
if Secion
you get 100 257
Total profit
If 5,7100 14.087 10.689 St 100 103.398 Se
If 57 100 100 25 103.398 203.398 257
N
a
Leete
19 us
norm of 10000 45 6736 6
d t 45
e
of 11 00210
N di 360527
v
t.iq
d eer
g
100J X 360527 36.05276
