HW 11 Solution

1.
(Binomial model, martingale probabilities, BS formula form)

In the one-period binomial model, the current stock price of GOOG is $640. Investors expect that in one
year the stock price of GOOG will be either $800 (up move) or $500 (down move). The exercise price of
one-year European call (put) option of GOOG=$650 and risk-free rate r=1% per annum.
(a) Calculate the risk-neutral (or martingale) probability for the up and down move using the savings
account as numeraire, respectively.
(b) Calculate the option prices of European call and put options using the risk-neutral valuation (or
martingale) approach.
(c) Find the martingale probability Q for the up and down move using the stock price as numeraire,
respectively. Note: You can use EQ[B(T)/S(T)|F(0)]=B(0)/S(0), where B(T)=1+r and B(0)=1. F(0)
represents the current information set (for instance, we know that the current stock price is S(0)).
(d) Use the martingale probability Q to calculate the current prices of European call and put options of
GOOG (per unit) with the stock price as numeraire. That is, E Q[EC(T)/S(T)|F(0)]=EC(0)/S(0), where
EC() is the value of European call option of GOOG per unit.
(e) EC0= S0*ProbQ{ST>K} (K/BT)*ProbP{ST>K}, find the value of EC0.
(f) EP0= (K/BT)*ProbP{K>ST} S0*ProbQ{K>ST}, find the value of EP0.
(g) Use numerical values from (e) and (f) to calculate [(S 0+EP0)] and [EC0+(K/BT)].
Answers:
(a) u*640=800, u=1.25; d*640=500, d=0.78125;
p (up) = (1+r-d)/(u-d) (1+0.01-0.78125)/(1.25-0.78125) 0.4880
1-p (down) = (u-1-r)/(u-d) (1.25-1-0.01)/(1.25-0.78125) 0.5120
(b) European call option price 0.4880*(150/1.01)+0.5120*(0/1.01) = $72.4752
European put option price 0.4880*(0/1.01)+0.5120*(150/1.01) = $76.0396
(c) EQ[B(T)/S(T)|F(0)]=B(0)/S(0) q*[(1+r)/uS]+(1-q)*[(1+r)/dS]=1/S (one variable q; one equation)
We can find the martingale probability measure Q
q={u(1+r-d)/[(u-d)(1+r)]}=p*u/(1+r);
(1-q)={d(u-1-r)/[(u-d)(1+r)]}=(1-p)*d/(1+r);
q0.4880*1.25/1.010.603960; (1-q)0.5120*0.78125/1.010.396040
(d) EQ[EC(T)/S(T)|F(0)]=EC(0)/S(0) EC/S=q*(Cu/(uS))+(1-q)*(Cd/(dS)
EC/640 = 0.603960*(150/800)+0.396040*(0/500) = 0.1132425 EC=72.4752
EQ[EP(T)/S(T)|F(0)]=EP(0)/S(0) EP/S=q*(Pu/(uS))+(1-q)*(Pd/(dS)
EP/640 = 0.603960*(0/800)+0.396040*(150/500) = 0.118812 EP=76.0397
(e) EC0= S0*ProbQ{ST>K} (K/BT)*ProbP{ST>K}
640*0.603960-(650/1.01)*0.488072.4750
(f) EP0= (K/BT)*ProbP{K>ST} S0*ProbQ{K>ST}
(650/1.01)*0.5120-640*0.39604076.0394
(g) (S0+EP0)=640+76.0394=716.0394
EC0+(K/BT)=72.4750+650/1.01 = 716.0394
Put call parity in the binomial model!
1
2. (Review: Binomial; replicating portfolios; European put option) In the one-period binomial model,
the stock price is $58 in the up move and $52 in the down move. Also, interest rate 1% (per annum),
time to maturity = 1 month, current risk-free bond (or CD) price B = $100, KOs current stock price S
$54.65, and KOs 55 European put option price is P (unknown). Nancy would like to construct a
portfolio with the stock and risk-free bond to replicate the payoff of 1,000 units of European put options.
(a) What is the gross payoff of 1,000 put options in the up move?
(b) What is the gross payoff of 1,000 put options in the down move?
(c) How many shares does Nancy need to buy or sell?
(d) How many units of risk-free bond does Nancy need to buy or sell?
(e) Calculate the current price of European put option (per unit) based on the binomial model.
(f) Find the time value of one put option contract based on part (e) (assuming that the option is an
American put).
Answers:
(a) Gross payoff = max(0, 55-58)*1,000 = $0
(b) Gross payoff = max(0, 55-52)*1,000 = $3,000
(c) 1,000*Pu = n*Su + B(1 + r); 1,000*Pd = n*Sd + B(1 + r)
n = 1000 *
(d) B =
Pu Pd
= 1,000*(0-3)/(58-52) = -500 (short sell stock)
Su Sd
1000 * Pu n * Su
= (0+500*58)/(1+1%*1/12) = $28,975.85 (buy bond; save money);
1+ r
(28,975.85)/100 = 289.76 (buy 289.76 units of risk-free bond)

(e) P= (-500*54.65+28975.85)/1,000 = $1.65
Note: Risk neutral valuation p=0.4490; (1-p)=0.5510
P = (0.4490*0+0.5510*3)/(1+1%*1/12)=1.65
(f) Time value = 100*(1.65-max(0,55-54.65)) = 100*(1.3) = $130

Key ideas for the binomial model (the replicating portfolio approach):
Step 1: Form the replicating portfolio nS+B
Step 2: This portfolio replicates the future payoff of an option. Two equations (for both up and
down states) Find the values of n and B.
Step 3: Portfolio payoff = option payoff in each state The option price = the portfolio value at
time 0 Find the option price.
3. (BS formula; call option price) The famous Black-Scholes formula for pricing a European call option
on a stock is presented as follows. Co = So N(d1 )Xe-rT N(d2);
2
S
T
ln o + r +
2
X
d1 =
T
d 2 = d1 T
Co = current call option premium, So = current stock price, X = exercise price,

= annual standard deviation of the stock, T = time to maturity in years,
r = annualized continuously compounded risk free rate,
N(d) = cumulative standard normal distribution,
e 2.71828, the base of natural logarithm, and ln = natural logarithm.
The following information is given for the European call option on KO (Coca-Cola). S=54.65, X=52.5,
rc=1% (continuously compounded interest rate), T=19 days, = 18% (annualized implied volatility).
(a) Find the value of ln(S/X), where ln = natural logarithm.
(b) Calculate d1 and d2 up to four decimal places.
(c) Find the values of N(d1) and N(d2) using the table of cumulative standard normal distribution
(attached in this file).
(d) Find the values of N(d1) and N(d2) using NORMSDIST() in EXCEL.
(e) Find the value of Xe-rT.
(f) Calculate the call option price Co using N(d1) and N(d2) from part (d).
Answers:
(a) ln(54.65/52.5) = 0.0401
(b) d1 = [ln(54.65/52.5)+(0.01+0.18*0.18/2)*19/365]/(0.18*sqrt(19/365)) = 1.0105
d2 = 1.0105-(0.18*sqrt(19/365)) = 0.9694
(c) N(d1) = N(1.01) = 0.8438; NORMSDIST(1.01)=0.8438
N(d2) = N(0.97) = 0.8340; NORMSDIST(0.97)=0.8340
(d) NORMSDIST(1.0105) = 0.8439;
NORMSDIST(0.9694) = 0.8338
(e) Xe-rT = 52.5*exp(-0.01*19/365) = 52.47
(f) C = 54.65*0.8439-52.5*exp(-0.01*19/365)*0.8338 = 2.37
Note: (1) Call option payoff = max(0, ST-X)
(2) From the binomial model, C=[pCu+(1-p)Cd]/(1+r) = discounted expected payoff in the riskneutral world.
(3) Co = SoN(d1 )Xe-rT N(d2); we can find the probability and discount factor in the BS model.
(4) S, X, r, , T d1, , T d2 Probability N(d1), N(d2) S, N(d1), Xe-rT , N(d2)
BS models call option price = C = S*N(d1)-Xe-rT*N(d2)
Standard Normal Probabilities, N(x) when x 0; N(-x) = 1-N(x)

z
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.0
0.5000
0.5040
0.5080
0.5120
0.5160
0.5199
0.5239
0.5279
0.5319
0.5359
0.1
0.5398
0.5438
0.5478
0.5517
0.5557
0.5596
0.5636
0.5675
0.5714
0.5753
0.2
0.5793
0.5832
0.5871
0.5910
0.5948
0.5987
0.6026
0.6064
0.6103
0.6141
0.3
0.6179
0.6217
0.6255
0.6293
0.6331
0.6368
0.6406
0.6443
0.6480
0.6517
0.4
0.6554
0.6591
0.6628
0.6664
0.6700
0.6736
0.6772
0.6808
0.6844
0.6879
0.5
0.6915
0.6950
0.6985
0.7019
0.7054
0.7088
0.7123
0.7157
0.7190
0.7224
0.6
0.7257
0.7291
0.7324
0.7357
0.7389
0.7422
0.7454
0.7486
0.7517
0.7549
0.7
0.7580
0.7611
0.7642
0.7673
0.7704
0.7734
0.7764
0.7794
0.7823
0.7852
0.8
0.7881
0.7910
0.7939
0.7967
0.7995
0.8023
0.8051
0.8078
0.8106
0.8133
0.9
0.8159
0.8186
0.8212
0.8238
0.8264
0.8289
0.8315
0.8340
0.8365
0.8389
1.0
0.8413
0.8438
0.8461
0.8485
0.8508
0.8531
0.8554
0.8577
0.8599
0.8621
1.1
0.8643
0.8665
0.8686
0.8708
0.8729
0.8749
0.8770
0.8790
0.8810
0.8830
1.2
0.8849
0.8869
0.8888
0.8907
0.8925
0.8944
0.8962
0.8980
0.8997
0.9015
1.3
0.9032
0.9049
0.9066
0.9082
0.9099
0.9115
0.9131
0.9147
0.9162
0.9177
1.4
0.9192
0.9207
0.9222
0.9236
0.9251
0.9265
0.9279
0.9292
0.9306
0.9319
1.5
0.9332
0.9345
0.9357
0.9370
0.9382
0.9394
0.9406
0.9418
0.9429
0.9441
1.6
0.9452
0.9463
0.9474
0.9484
0.9495
0.9505
0.9515
0.9525
0.9535
0.9545
1.7
0.9554
0.9564
0.9573
0.9582
0.9591
0.9599
0.9608
0.9616
0.9625
0.9633
1.8
0.9641
0.9649
0.9656
0.9664
0.9671
0.9678
0.9686
0.9693
0.9699
0.9706
1.9
0.9713
0.9719
0.9726
0.9732
0.9738
0.9744
0.9750
0.9756
0.9761
0.9767
2.0
0.9772
0.9778
0.9783
0.9788
0.9793
0.9798
0.9803
0.9808
0.9812
0.9817
2.1
0.9821
0.9826
0.9830
0.9834
0.9838
0.9842
0.9846
0.9850
0.9854
0.9857
2.2
0.9861
0.9864
0.9868
0.9871
0.9875
0.9878
0.9881
0.9884
0.9887
0.9890
2.3
0.9893
0.9896
0.9898
0.9901
0.9904
0.9906
0.9909
0.9911
0.9913
0.9916
2.4
0.9918
0.9920
0.9922
0.9925
0.9927
0.9929
0.9931
0.9932
0.9934
0.9936
2.5
0.9938
0.9940
0.9941
0.9943
0.9945
0.9946
0.9948
0.9949
0.9951
0.9952
2.6
0.9953
0.9955
0.9956
0.9957
0.9959
0.9960
0.9961
0.9962
0.9963
0.9964
2.7
0.9965
0.9966
0.9967
0.9968
0.9969
0.9970
0.9971
0.9972
0.9973
0.9974
2.8
0.9974
0.9975
0.9976
0.9977
0.9977
0.9978
0.9979
0.9979
0.9980
0.9981
2.9
0.9981
0.9982
0.9982
0.9983
0.9984
0.9984
0.9985
0.9985
0.9986
0.9986
3.0
0.9987
0.9987
0.9987
0.9988
0.9988
0.9989
0.9989
0.9989
0.9990
0.9990

HW 11 Solution

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1.

(Binomial model, martingale probabilities, BS formula form)

(28,975.85)/100 = 289.76 (buy 289.76 units of risk-free bond)

(f) Time value = 100(1.65-max(0,55-54.65)) = 100(1.3) = $130

Co = current call option premium, So = current stock price, X = exercise price,

Standard Normal Probabilities, N(x) when x 0; N(-x) = 1-N(x)

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