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DS2 Revision
Rachel enters into a put ratio spread where she buys a 40-strike put option and sells two 35-strike put
options. The stock price is 35, the stock’s volatility is 0.3 per annum and the continuously compounded risk-free
interest rate is 0.03 per annum. The following is the information on the put options:

Strike Price Premium Delta Gamma Theta (per day)

35 1.944 -0.451 0.076 -0.010

40 5.319 -0.780 0.057 -0.006

Calculate the investment required for Rachel to immediately delta-hedge her position.
Δspread = Δ40 − 2Δ35
​ ​ ​

= −0.780 − 2(−0.451)
= 0.122 ​  ​

Investment = (5.319 − 2 × 1.944) − 35 × 0.122

= −2.839

Approximate Rachel’s overnight profit if the stock price tomorrow decreases by 1.5

C(S35,2 ) = 1.944 − 0.451(−1.5) + 0.5(0.076)(−1.5)2 − 0.010

​

= 2.696
C(S40,2 ) = 5.319 − 0.780(−1.5) + 0.5(0.057)(−1.5)2 − 0.006
​

= 6.547125
C(Spread) = 6.547125 − 2 × 2.696
= 1.155125 ​ 
​

C(Spread)0 = 5.319 − 2 × 1.944 ​

= 1.431
Profit = −(1.155125 − 1.431) + 0.122(−1.5) + 2.839 (e0.03/365 − 1)
= 0.09310835206

At which stock prices, one day after the initial investment was made, will Rachel break even?
Let h = Changes in Stock Price
C(S35,2 ) = 1.944 − 0.451h + 0.5(0.076)h2 − 0.010
​

C(S40,2 ) = 5.319 − 0.780h + 0.5(0.057)h2 − 0.006

​

C(Spread) = C(S40,2 ) − 2C(S35,2 ) ​ ​

= 1.445 + 0.122h − 0.0475h2

​

​

Profit = −(1.445 + 0.122h − 0.0475h2 − 1.431) + 0.122h + 2.839 (e0.03/365 − 1) = 0

h = ±0.538353199
Stock = 35.5383532 or 34.4616468

X(t)and Y (t)are Ito processes representing the prices of dividend-paying stocks. Given:

DS2 Revision 1
 dX(t) = 0.17X(t)dt + 0.25XdZ(t)

Y (t) = 0.15t + 0.31Z(t)
​ ​

where
Z(t)is a standard Brownian motion. Both X(t) and Y (t)pays the same continuously compounded annual
dividend rate of δand the continuously compounded risk-free interest rate is 0.08 per annum. Find δ
dY
​= (0.15 + 0.5 × 0.312 )dt + 0.31dZ
Y
(0.19805 + δ) − 0.08
ϕY =
0.31
​ ​

(0.17 + δ) − 0.08
​  ​

ϕX =
0.25
​ ​

ϕY = ϕX ​ ​

δ = 0.026875

A stock’s current price is 80 and the stock pays a continuously compounded dividend at a rate of 0.02 per
annum. The continuously compounded annual rate of return on the stock is 0.15 and the continuously
compounded risk-free interest rate is 0.05 per annum. The stock’s volatility is 0.2 per annum. Use the following
uniform numbers and the inversion method to generate payoffs for a 75 strike European call option on the
stock that expires in two years:
0.3821
0.0217
0.4681
0.9803
0.6985
Hence, determine the expected value of the call option

z = [−0.29997003667, −2.01989915, −0.0800468408, 2.059984783, 0.520091144]

m = (r − δ − 0.5σ 2 )2
= 0.02
ν=σ 2 ​

= 0.2828427125
S1 = 74.97706718 ​

S2 = 46.09538701 ​
​ 
​

S3 = 79.78902543 ​

S4 = 146.1565516 ​

S5 = 94.55017298 ​

1
E[C] = (19.09915) e−0.05(2)
5
​

= 17.28162557

Consider the Black-Scholes framework. A market-maker sells 20 three-month 51-strike European call
options on a dividend-paying stock and delta hedges his position. The current stock price is 50, the stock pays
a continuously compounded dividend of 2.5% ad the continuously compounded risk-free rate is 8%. To delta
hedge his position, the market maker trades shares worth 540.42

Calculate the stock’s annual volatility, σ , correct to two decimal places where 0 < σ < 1

( )

DS2 Revision 2
 Δ = 20Se−δ(T −t) N(d1 ) ​

−0.025(0.25)
540.42 = 20(50)e N(d1 ) ​

N(d1 ) = 0.5438082021
​

d1 = 0.1100325022
​
​  ​

ln(S/K) + (r − δ + 0.5σ 2 )T
= ​

σ T ​

σ = 0.5312717275

It is known that the market-maker makes zero profit or loss after one day. Assuming there are 365 days
in a year, calculate the stock price’s movement over one day to achieve this.

540.42 (e0.025( 365 ) − 1) = 20Δ(−h)

1
​

​ 
​

h = −0.0034247748

A risk-neutral probability of an upward movement of 0.6 is assumed. The following is a binomial tree model
of effective annual interest rates with each period being three months:
0.05 0.076 0.087 0.0116
0.0653 0.0765 0.0319

0.0673 0.0875
​ ​ ​ ​

0.2403
Construct a binomial tree model of three-month zero-coupon bond prices.
0.9878765474 0.9818540416 0.9793605679 0.9971208438
0.9843102741 0.9817400118 0.9921802934

0.9838488281 0.9792479783
​ ​ ​ ​

0.9475852983
Calculate the premium of a six-month European call option that allows the purchase of a six-month zero-
coupon bond at the price of 0.96

0 25

DS2 Revision 3
 (1 + r)−0.25 = 0.96
r = 0.1773756993
Cuud ​ = 0.99218029345
Cudd ​ = 0.97924797828
Cuuu ​ = 0.99712084379
Cuu ​ = 1.087−0.25 (0.6 × Cuuu + 0.4 × Cuud )
​ ​

= 0.9746054036
Cud ​ = 0.9689846245
Cdd = 0.9509714596
​

Cu = 0.9547127407
​

Cd = 0.946689304​

P (0, 1) = 0.9399678601
P (0, 0.5) = 1.05−0.25 (0.6 × 1.076−0.25 + 0.4 × 1.0653−0.25 )
= 0.9709211625
P (0, 1)
F0.5,1 =
P (0, 0.5) 
​ ​

​ ​

0.9399678601
=
0.9709211625
​

S = 0.9681196542
K = 0.96
0.0653e2σ t
= 0.0760
​

σ = 0.151741304
ln ( K
S
) + 0.5σ 2 t
d1 =
​

​ ​

σ t ​

= 0.1321446118
d2 = d1 − σ t ​ ​ ​

= 0.02484730675
N(d1 ) = 0.552562
​

N(d2 ) = 0.509909
​

C = P (0, 0.5) [FN(d1 ) − KN(d2 )] ​ ​

= 0.04411233922

DS2 Revision 4