Hw4 Mfe Au14 Solution

ACTS 4302
Instructor: Natalia A. Humphreys

SOLUTION TO HOMEWORK 4
Lesson 6: Binomial trees: miscellaneous topics.
Lesson 7: Modeling stock prices with the lognormal distribution.
Problem 1
For a 1-year American put option on a stock with 6 months left to expiry, you are given:
(i) The strike price is 42.
(ii) The continuous dividend rate for the stock is 0.03.
(iii) 6 months before expiry, the stock price is 33.
(iv) The value of a 6-month call option on the stock with a strike price of 42 is 0.155.
Calculate the lowest possible continuously compounded risk-free rate so that exercising the option at
6 months before expiry is optimal.
Solution. Since early exercise is optimal, the present value of interest on the strike price must exceed
the present value of dividends plus the value of the implicit call option:
K(1 ert ) S(1 et ) + C
The present value of dividends is:

33 1 e0.50.03 = 0.4913
The value of the call option is given as 0.155. The present value of interest on the strike price is

42 1 e0.5r
Hence,

42 1 e0.5r 0.4913 + 0.155 = 0.6463
e0.5r = 0.9846
r = 0.031

Problem 2
The Jarrow-Rudd binomial tree is used to price an option on a non-dividend paying stock. You are
given:
(i) The risk-free rate is 0.045.
(ii) The annual volatility is 29%.
(iii) The period of the binomial tree is 7 months.
Determine the risk-neutral probability of an up move.
Solution. Recall that for a Lognormal (Jarrow-Rudd) tree:
u = e(r0.5
2 )h+
, d = e(r0.5
2 )h
and p =
e(r)h d
ud
Hence,
2
u = e0.5833[0.0450.5(0.29 )]+0.29 0.5833 = e0.2232 = 1.2501

2
d = e0.5833[0.0450.5(0.29 )]0.29 0.5833 = e0.2198 = 0.8027
e0.0450.5833 0.8027
1.0266 0.8027
p =
=
= 0.5005
1.2501 0.8027
0.4474
Copyright Natalia A. Humphreys, 2014
ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 4.
Problem 3
A Cox-Ross-Rubinstein binomial tree is used to model an option. You are given:
(i) The continuously compounded risk-free rate is 5%.
(ii) = 0.06.
(iii) = 0.
Determine the largest period for which this tree can be used without violating arbitrage conditions
on the nodes.
Solution. To avoid arbitrage, u and d must satisfy:
d < e(r)h < u
For a Cox-Ross-Rubinstein tree:
u = e
, d = e
Thus, to avoid arbitrage, we need e(r)h < u e(r)h < e

e
h.
Since = 0,
0.06 h
> erh e
> e0.05h
6
0.06 h > 0.05h h < h < 1.44
5

Problem 4
An American company expects to receive 450,000 from sales in England at the end of 9 months.
The current exchange rate is $1.5/. The company would like to guarantee that it will get at least
this rate when it receives the pounds, so that it will receive at least $675,000.
You are given:
(i)
(ii)
(iii)
(iv)
The continuously compounded risk-free rate in dollars is 4.3%.

The continuously compounded risk-free rate in pounds is 3.5%.
Relative volatility of the currencies is 0.2.
A two-period Cox-Ross-Rubinstein binomial tree is used to determine the price of options.
Determine the cost of an option, in dollars, which will guarantee the current exchange rate at the
end of 9 months.
Solution. The company should purchase a European put on pounds with strike price 1.50. For this
option, the domestic currency is dollars and the foreign currency is pounds. Thus,
r = rd = r$ = 0.043
= rf = r = 0.035
Also, note that h = 0.75/2 = 0.375.
In a Cox-Ross-Rubinstein binomial tree the up and down movements, and the risk-neutral probability
of an up move, are
h
= e0.2 0.375
= 1.1303
u = e
h
0.2 0.375
d=e
=e
= 0.8847
u d = 0.2456
e(r)h d
e(0.0430.035)0.375 0.8847
p =
=
= 0.4817
ud
0.2456
1 p = 0.5183
The spot exchange rate tree:

Page 2 of 7
u2 x0 = 1.9163
ux0 = 1.6954
x0 = 1.5
udx0 = 1.5
dx0 = 1.3271
ddx0 = 1.1741
The put tree:
Puu = 0
Pu
Pud = 0
P
Pd
Pdd = 0.3259
Pd = erh (p Pud + (1 p )Pdd ) = e0.0430.375 0.5183 0.3259 = 0.1662

Since the put is the European put, we continue with this value of Pd :
P = e0.0430.375 0.5183 0.1662 = 0.0848$/
This is the cost of a put to buy 1. The total price of a put on 450,000 is:
450,000 0.0848 = 38,143.61
Note that if the put were an American put, the answer would be slightly different:
If exercised, 1.5 1.3271 = 0.1729. Since 0.1729 > 0.1662, we use 0.1729 in further calculations:
P = e0.0430.375 0.5183 0.1729 = 0.0882$/
This is the cost of a put to buy 1. The total price of a put on 450,000 is:
450,000 0.0882 = 39,684.74

Problem 5
You are given the following information on the price of a stock:
Page 3 of 7
Date
Stock price
Jul. 1, 2007
35.30
Aug. 1, 2007
33.90
Sep. 1, 2007
41.20
Oct. 1, 2007
31.95
Nov. 1, 2007
38.25
Dec. 1, 2007
46.18
Estimate the annual volatility of continuously compounded return on the stock.

(A) 0.20
(B) 0.62
(C) 0.68
(D) 0.69
(E) 0.75
Key: D
Solution. To estimate volatility from historical data:
s
P
P 2

xt
n
St
xt
2
x
, where xt = ln
, x
=
= N
n1
n
St1
n
N is the number of periods per year, n is the number one less than the number of observations of
stock price.
In our problem N=12 and n=5. We calculate xt = ln(St /St1 ) and x2t :
St
xt
x2t
35.30
33.90 -0.0405 0.0016
41.20
0.1950
0.0380
31.95 -0.2543 0.0647

38.25
0.1800
0.0324
46.18
0.1884
0.0355
Summing up the third column and its squares,

5
X
X
0.2687
= 0.05373,
x2t = 0.1722
5
t=1
t=1

5
0.1722
s2 =
0.053732 = 0.03944, s = 0.03944 = 0.1986
4
5
That is the monthly volatility. The annual volatility is
0.1986 12 = 0.688 0.69

xt = 0.2687, x
=
Problem 6
A stocks price follows a lognormal model. You are given:
(i) The current price of the stock is 105.
(ii) The probability that the stocks price will be less than 98 at the end of 6 months is 0.3483.
Page 4 of 7
(iii) The probability that the stocks price will be less than 115 at the end of 9 months is 0.7123.
Calculate the expected price of the stock at the end of one year.
Solution. Recall from Lesson 7 that probabilities of payoffs of stock prices are:
P r(St < K) = N (d2 ), and P r(St > K) = N (d2 ), where

ln SK0 + ( + 0.5 2 )t
ln SK0 + ( + 2 )t
d1 =
=
t
t

ln SK0 + t
ln SK0 + ( 0.5 2 )t
=
d2 =
t
t
d2 = d1 t
Hence, our statements could be written as:
P r (S0.5 < 98) = N (d2 (0.5)) = 0.3483
P r (S0.75 < 115) = N (d2 (0.75)) = 0.7123
Calculating d2 (0.5) and d2 (0.75), we obtain:
105
98 +
ln
d2 (0.5) =
ln
d2 (0.75) =
0.5
0.5
105
115 +
0.75
0.069 + 0.5
0.7071
=
0.091 + 0.75
0.866
0.75
On the other hand, using the standard normal probability table for N (z) = 0.3483 and N (z) = 0.7123,
we obtain:
d2 (0.5) = 0.39
d2 (0.75) = 0.56
Thus, we solve the system:
0.069+0.5
0.7071
= 0.39
0.069 + 0.5 = 0.2758
0.091+0.75
0.091 + 0.75 = 0.485
= 0.56
0.866
0.5 0.2758 = 0.069

0.5517 = 0.138
0.75 + 0.485 = 0.091

+ 0.6467 = 0.1213
to obtain: = 0.2164, = 0.01864. Therefore, m = t = 0.01864t, v 2 = 2 t = 0.0468t and the
expected value of the stock after one year is
2
E[S1 ] = S0 em+0.5v = 105e0.01864+0.50.0468 = 105.5025

This problem could be solved slightly differently, using the theory of percentiles.
The probability statements result in these two equations expressing the percentiles in terms of standard normal coefficients of the 100pth percentile, or zp :
105e0.5+ 0.5z0.3483 = 98
105e0.75+ 0.75z0.7123 = 115
The normal percentiles are: z0.3483 = 0.39 and z0.7123 = 0.56. Hence,
0.5 0.2758 = 0.069
0.75 + 0.485 = 0.091
This is the same system as in the first approach above.
Page 5 of 7
Problem 7
(i) The initial price is 95.
(ii) = 0.14.
(iii) = 0.07.
(iv) = 0.4.
Construct a 95% confidence interval for the price of the stock at the end of five years.
Solution. The lognormal parameter m for the distribution of the stock price after five years is
( 0.5 2 )t = (0.14 0.07 0.5 0.42 )5 = 0.05
The lognormal parameter v is 0.4 5 = 0.8944. The confidence interval is

0.05 1.96(0.8944) = (1.8031, 1.7031)
Exponentiating, we get

e1.8031 , e1.7031 = (0.1648, 5.4909)
Multiplying by the initial stock price of 95, the answer is (15.66, 521.64).

Problem 8
A stocks price follows a lognormal model. The current price of the stock is 50. A 95% confidence
interval for the price of the stock at the end of one year is (41.20, 73.05).
Construct a 90% confidence interval for the price of the stock at the end of two years.
Solution. We know that
41.20 = 50e1.96 and 73.05 = 50e+1.96
so the quotient is:
73.05
= 1.7731
41.20
ln 1.7731
=
= 0.1461
3.92
e3.92 =
and the product is

e2 =
We need
41.20 73.05
= 1.2039
502
50e21.645
and 50e2+1.645
Calculating:
e1.645 2 =e1.645 20.1461 = 1.4049

50e21.645 2 = 50(1.2039)/1.4049 = 42.85
50e2+1.645
= 50(1.2039)(1.4049) = 84.56
Thus the 90% confidence interval for the price of the stock at the end of two years is (42.85, 84.56).

Problem 9
(i) The stocks initial price is 60.
(ii) The stocks continuously compounded rate of return is 0.06.
(iii) The stocks continuously compounded dividend rate is 0.03.
Page 6 of 7
(iv) Volatility is 0.25.

Calculate the conditional expected value of the stock after 1 year given that it is greater than 70.
Solution. We use the formula
E[St |St > K] =
S0 e()t N (d1 )
N (d2 )
Calculating d1 and d2 :

ln SK0 + ( + 0.5 2 )t
ln (60/70) + 0.06 0.03 + 0.5(0.252 )
d1 =
=
= 0.3716
0.25
t
d2 = d1 t = 0.3716 0.25 = 0.6216

Then
N (0.3716)
=
N (0.6216)
1 N (0.3716)
1 N (0.3716)
= 61.8273
= 61.8273
1 N (0.6216)
1 N (0.6216)

1 N (0.37)
1 0.6443
61.8273
= 61.8273
= 82.1822
1 N (0.62)
1 0.7324
E[St |St > 70] = 60e0.03

Problem 10
(i) The stocks initial price is 42.
(ii) The stocks continuously compounded rate of return is 0.156.
(iii) The stocks continuously compounded dividend rate is 0.03.
(iv) Volatility is 0.36.
A European call option on the stock expires in 6 months and has strike price 47.
Calculate the expected payoff for the call option.
Solution. We use the formula
E[max(0, St K)] = S0 e()t N (d1 ) KN (d2 )
Calculating d1 and d2 :

S0
ln
+ ( + 0.5 2 )t
ln (42/47) + (0.156 0.03 + 0.5(0.362 ))0.5
K
d1 =
=
= 0.0671 0.07
t
0.36 0.5
d2 = d1 t = 0.0671 0.36 0.5 = 0.3217 0.32

N (d1 ) = N (0.07) = 1 N (0.07) = 1 0.5279 = 0.4721
N (d2 ) = N (0.32) = 1 N (0.32) = 1 0.6255 = 0.3745
The expected payoff for the call option is
E[max(0, St K)] = 42e0.063 (0.4721) 47(0.3745) = 3.5161
Page 7 of 7

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ACTS 4302

Instructor: Natalia A. Humphreys

u = e0.5833[0.0450.5(0.29 )]+0.29 0.5833 = e0.2232 = 1.2501

Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 4.

Thus, to avoid arbitrage, we need e(r)h < u e(r)h < e

The continuously compounded risk-free rate in dollars is 4.3%.

The spot exchange rate tree:

Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 4.

The put tree:

Pd = erh (p Pud + (1 p )Pdd ) = e0.0430.375 0.5183 0.3259 = 0.1662

Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 4.

Estimate the annual volatility of continuously compounded return on the stock.

31.95 -0.2543 0.0647

Summing up the third column and its squares,

0.1986 12 = 0.688 0.69

Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 4.

0.069 + 0.5 = 0.2758

0.5 0.2758 = 0.069

0.75 + 0.485 = 0.091

E[S1 ] = S0 em+0.5v = 105e0.01864+0.50.0468 = 105.5025

Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 4.

The lognormal parameter v is 0.4 5 = 0.8944. The confidence interval is

and the product is

e1.645 2 =e1.645 20.1461 = 1.4049

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 4.

Copyright Natalia A. Humphreys, 2014

(iv) Volatility is 0.25.

d2 = d1 t = 0.3716 0.25 = 0.6216

E[St |St > 70] = 60e0.03

d2 = d1 t = 0.0671 0.36 0.5 = 0.3217 0.32

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