Hw1 Mfe Au14 Solution

ACTS 4302
Instructor: Natalia A. Humphreys

SOLUTION TO HOMEWORK 1
Lesson 0: Review of derivative instruments
Lesson 1: Put-Call Parity
Problem 1
For a non-dividend paying stock, you are given:
(i) Its current price is 32.
(ii) A European call option on the stock with one year to expiration and strike price 26 costs 8.15.
(iii) The continuously compounded risk-free rate is 0.055.
Determine the premium of a 1-year European put option on the stock with strike 26.
Solution. We are given:
S = 32, T = 1, K = 26, C = 8.15, r = 0.055
We need to find P .
By PCP for non-dividend paying stock,
C(S, K, T ) P (S, K, T ) = S0 KerT
P (S, K, T ) = C(S, K, T ) S0 + KerT = 8.15 32 + 26e0.055 = 0.7586 0.76
Problem 2
A stock pays dividends proportionate to its value at rate . You are given:
(i) The stock price is 45.
(ii) The continuously compounded risk-free rate is 5%.
(iii) A 3-month European call option on the stock with strike 45 costs 4.20.
(iv) A 3-month European put option on the stock with strike 45 costs 3.81.
Determine .
S = 45, r = 0.05, T = 0.25, K = 45, C = 4.20, P = 3.81
We need to find .
By PCP for a dividend paying stock with continuous dividends,
C(S, K, T ) P (S, K, T ) = S0 eT KerT
S0 eT = C(S, K, T ) P (S, K, T ) + KerT

C(S, K, T ) P (S, K, T ) + KerT
1
= ln
=
T
S0

1
4.20 3.81 + 45e0.050.25
=
ln
= 0.01505 1.51%
0.25
45
Problem 3
A stock has price 50. Dividends of 3 are payable every four months, with the next dividend payable
at the end of one month. You are given:
(i) The continuously compounded risk-free rate is 7%.
(ii) A 4-month European put option with strike 55 costs 7.49.
Determine the premium of a 4-month European call option on the stock with strike 55.
Copyright Natalia A. Humphreys, 2014
ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 1.

1
1
S = 50, T = , K = 55, P = 7.49, r = 0.07, t = , D = 3
3
12
We need to find C.
By PCP for a dividend paying stock with discrete dividends,
C(S, K, T ) P (S, K, T ) = S0 Dert KerT
1
C(S, K, T ) = 7.49 + 50 3 e 12 0.07 55e0.07 3 =

= 0.7759 0.78
Problem 4
For 2 stocks, S1 and S2 :
(i) The price of S1 is 25.
(ii) S1 pays continuous dividends at a rate of 1%.
(iii) The price of S2 is 65.
(iv) S2 pays continuous dividends at a rate of 4%.
A 1-year call option to receive a share of S2 in exchange for 2.5 shares of S1 costs 3.50.
Determine the premium of a 1-year call option to receive 1 share of S1 in exchange for 0.4 shares of
S2 .
Solution. Recall that the definitions of calls and puts are mirror images. A put to sell S for Q is
the same as a call to purchase Q for S:
P (St , Qt , T t) = C(Qt , St , T t)
Thus, PCP for exchange options could be re-written as:
C(St , Qt , T t) C(Qt , St , T t) = St eS (T t) Qt eQ (T t)
Here S is the stock being received and Q is the stock being paid with.
In our case, we are receiving one share of stock S2 for 2.5 shares of stock S1 . Thus,
S = S2 = 65, Q = 2.5S1 = 2.5 25 = 62.5 and
C(S, Q, T ) = C(S2 , 2.5S1 , T ) = C(65, 62.5, 1) = 3.5
Then C(Q, S, T ) in the formula above is
C(Q, S, T ) = C(2.5S1 , S2 , T )
But to receive 2.5 shares of stock S1 for one share of stock S2 is equivalent to receiving one share of
1
= 0.4 shares of stock S2 and
stock S1 for 2.5
C(Q, S, T ) = C(2.5S1 , S2 , T ) = 2.5C(S1 , 0.4S2 , T ),
which is exactly what need to find.
We are given that
S = S2 = 0.04 and Q = S1 = 0.01
Therefore,
C(Q, S, T ) = C(S, Q, T ) SeS T + QeQ T
2.5C(S1 , 0.4S2 , 1) = 3.5 65e0.04 + 62.5e0.01 = 2.9268 C(S1 , 0.4S2 , 1) = 2.9268/2.5 1.17
Problem 5
You are given:
(i) The spot exchange rate is 1.7$/.
(ii) The continuously compounded risk-free rate in dollars is 6.3%.
Page 2 of 5
(iii) The continuously compounded risk-free rate in pounds sterling is 3.4%.

(iv) A 6-month dollar-denominated European put option on pounds with a strike of 1.7$/ costs
$0.04
Determine the premium in pounds of a 6-month pound-denominated European call option on dollars
1
with a strike of 1.7
/$.
Solution. We are given the information for domestic currency = dollars and foreign currency
= pounds. We have:
x0 = 1.7, T = 0.5, K = 1.7, Pd (x0 , K, T ) = 0.04, rd = 0.063, rf = 0.034

We need to find Cf x10 , K1 , T .
Note that Call-Put relationship in foreign and domestic currency:

1 1
1
, ,T =
Pd (x0 , K, T )
Cf
x0 K
Kx0
Hence,
Cf =
1
0.04 = 0.0138
1.7 1.7
Problem 6
For conditions in Problem 5, determine the premium in pounds of a 6-month pound-denominated
1
/$.
European put option on dollars with a strike of 1.7
Solution. Since we need to find a pound denominated value of a put, and weve already found a
pound denominated value of a call in the previous problem the domestic currency now is pounds
and the foreign currency is dollars. Also,
1
1
, K=
, rd = 0.034, rf = 0.063
1.7
1.7
By PCP for currency options with x0 as a spot exchange rate:
x0 =
C(x0 , K, T ) P (x0 , K, T ) = x0 erf T Kerd T

Therefore,
P (x0 , K, T ) = C(x0 , K, T ) x0 erf T + Kerd T =
1 0.0630.5
1 0.0340.5
= 0.0138
e
+
e
= 0.0222 0.02
1.7
1.7
Problem 7
You are given:
(i) The spot exchange rate of yen for euros is 120U/e.
(ii) The continuously compounded risk-free rate for yen is 1.5%.
(iii) The continuously compounded risk-free rate for euros is 3%.
(iv) A one year yen-denominated call on euros costs U4.
(v) A one year yen-denominated put on euros with the same strike price as the call costs U3.
Determine the strike price in yen.
Solution.
In this Problem, the domestic currency is yen U and the foreign currency is euros e. We are
given:
x0 = 120, rd = 0.015, rf = 0.03, C = 4, P = 3
We need to determine K.
Page 3 of 5
By PCP for currency options with x0 as a spot exchange rate:

C(x0 , K, T ) P (x0 , K, T ) = x0 erf T Kerd T

K = erd T P (x0 , K, T ) C(x0 , K, T ) + x0 erf T =

= e0.0151 3 4 + 120e0.03 = 117.1983 117.20
Problem 8
A European call option allows one to purchase 3 shares of Stock B with 1 share of stock A at the end
of a year. You are given:
(i) The continuously compounded risk-free rate is 4%.
(ii) Stock A pays dividends at a continuous rate of 3%.
(iii) Stock B pays dividends at a continuous rate of 2%.
(iv) The current price for Stock A is 80.
(v) The current price for Stock B is 35.
A European put option which allows one to sell 3 shares of Stock B for 1 share of Stock A costs 14.35.
Determine the premium of a European call option, which allows one to purchase 1 share of Stock A
for 3 shares of Stock B at the end of a year.
Solution. The option to receive 1 share of Stock A for 3 shares of stock B is the same as the option
to sell 3 shares of Stock B for 1 share of Stock A, which is the put option given in the problem. So
the premium for this call option is 14.35.
Problem 9
For a stock you are given:
(i) It pays semiannual dividends of 1.60.
(ii) It has just paid a dividend.
(iii) Its price is 77.
(iv) The continuously compounded risk-free interest rate is 5%.
Calculate the forward price for an agreement to deliver 200 shares of the stock fifteen months from
now.
D = 1.6 paid at times t1 = 0.5, t2 = 1, S = 77, r = 0.05, T = 1.25
The forward price on a stock with discrete dividends is

F = SerT F V (D) = 77e0.051.25 1.6 e0.750.05 + e0.250.05 = 78.6848
To deliver 200 shares:
200F = 200 78.6848 = 15,736.96
Problem 10
A pound-denominated forward agreement provides for the delivery of e150 at the end of 9 months.
The continuously compounded risk-free rate for euros is 4%, and the continuously compounded riskfree rate for pounds is 2%. The current exchange rate is 0.9 /e.
Calculate the forward price in pounds for this agreement.
Solution. We are given: domestic = pounds, foreign=euros
T = 0.75, rf = 0.04, rd = 0.02, x0 = 0.9
Then the forward price to deliver on euro for pounds is
F = x0 e(rd rf )T = 0.9e(0.020.04)0.75 = 0.8866
Page 4 of 5
For the delivery of e150: 150 0.8866 = 132.99
Page 5 of 5

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ACTS 4302

Instructor: Natalia A. Humphreys

Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 1.

Solution. We are given:

C(S, K, T ) = 7.49 + 50 3 e 12 0.07 55e0.07 3 =

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 1.

Copyright Natalia A. Humphreys, 2014

(iii) The continuously compounded risk-free rate in pounds sterling is 3.4%.

C(x0 , K, T ) P (x0 , K, T ) = x0 erf T Kerd T

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 1.

Copyright Natalia A. Humphreys, 2014

By PCP for currency options with x0 as a spot exchange rate:

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 1.

Copyright Natalia A. Humphreys, 2014

For the delivery of e150: 150 0.8866 = 132.99

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