Solutions to Homework 10

FM 5021 Mathematical Theory Applied to Finance

13.2 The volatility of a stock price is 30% per annum. What is the standard deviation of the percentage price change in one trading day? Let us assume that there are 252 trading days in one year. The standard deviation of the percentage price change in a period t is t, where is the volatility. Therefore, the standard deviation of the percentage price change in one trading day is r 1 t = 0.3 = 0.0189, or 1.89%. 252 13.4 Calculate the price of a 3-month European put option on a non-dividendpaying stock with a strike price of $50 when the current stock price is $50, the risk-free interest rate is 10% per annum, and the volatility is 30% per annum. The price of a European put option is given by the formula p = KerT N (d2 ) S0 N (d1 ), where ln d1 = ln d2 =
S0 K

S0 K

+ r+ T + r T

2 2

T T .

2 2

In our case, S0 = 50, K = 50, r = 0.1, = 0.3, and T = 0.25. Thus, 0 .3 2 ln 50 + 0 . 1 + 0.25 50 2 d1 = = 0.2417 0.3 0.25 50 0 .3 2 ln 50 + 0.1 2 0.25 d2 = = 0.0917, 0.3 0.25 and, therefore, p = 50e0.10.25 N (0.0917) 50N (0.2417) Z 0.0917 Z 0.2417 2 x2 1 x 0.10.25 1 = 50e e 2 dx 50 e 2 dx 2 2 0.10.25 = 50e 0.4634 50 0.4045 = $2.37. 1

13.6 What is implied volatility? How can it be calculated? Implied volatility is the volatility that makes the Black-Scholes price of an option equal to its market value. It can be calculated by solving the nonlinear equation obtained by setting the Black-Scholes price equal to the market price. This equation can be solved using an interative method, such as the Newton-Raphson method. 13.7 A stock price is currently $40. Assume that the expected return from the stock is 15% and that its volatility is 25%. What is the probability distribution for the rate of return (with continuous compounding) earned over a 2-year period? The rate of return with continuous compounding earned over a period T follows the distribution 2 , , 2 T where is the expected return from the stock and is the stocks volatility. In our case, = 0.15, = 0.25, and T = 2. Therefore, the probability distribution of the rate of return earned over a period of 2 years is 0.252 0.25 0.15 , = (0.11875, 0.1768), 2 2 i.e. the expected value of the return is 11.875% per annum and the standard deviation is 17.68% per annum. 13.9 Using the notation in this chapter, prove that a 95% condence interval for ST is between S0 e
2 T 1.96 T 2

and S0 e

2 T +1.96 T 2

From (13.3) we know that ln ST has the probability distribution 2 ln S0 + T, T . 2 Therefore, a 95% condence interval for ln ST is 2 2 ln S0 + T 1.96 T , ln S0 + T + 1.96 T . 2 2 A 95% condence for ST is, therefore, 2 2 ln S0 + T 1.96 T ln S0 + T +1.96 T 2 2 e ,e , i.e. S0 e
2 T 1.96 T 2

, S0 e 2

2 T +1.96 T 2

13.11 Assume that a non-dividend-paying stock has an expected return of and a volatility of . An innovative nancial institution has just announced that it will trade a security that pays o a dollar amount equal to ln ST at time T , where ST denotes the value of the stock price at time T . (a) Use risk-neutral valuation to calculate the price of the security at time t in terms of the stock price, S , at time t. From (13.3), the expected value of ln ST at time t is 2 ln S + (T t). 2 The expected value of ln ST in a risk-neutral world is, therefore, 2 ln S + r (T t), 2 since in a risk-neutral world the expected return is equal to the risk-free rate. Using riskneutral valuation the value of the security at time t is 2 r(T t) e ln S + r (T t) . 2 (b) Conrm that your price satises the dierential equation (13.16). Let 2 r(T t) (T t) . f =e ln S + r 2 Then, f 2 2 r(T t) r(T t) = re ln S + r (T t) e r t 2 2 r(T t) e f = S S 2f er(T t) = . S2 S2 Substituting in the left-hand side of the Black-Scholes equation, we obtain f f 1 2 2 2f 2 2 2 r(T t) + rS + S = e r ln S + r r ( T t ) r + r t S 2 S2 2 2 2 2 = rer(T t) ln S + r (T t) 2 = rf, i.e. f satises the Black-Scholes equation.

13.13 What is the price of a European call option on a non-dividend-paying stock when the stock price is $52, the strike price is $50, the risk-free interest rate is 12% per annum, the volatility is 30% per annum, and the time to maturity is 3 months? The price of a European call option is given by the formula c = S0 N (d1 ) KerT N (d2 ), where 2 + r + 2 T d1 = T S0 2 ln K + r 2 T d2 = . T In our case, S0 = 52, K = 50, r = 0.12, = 0.3, and T = 0.25. Thus, 0 .3 2 ln 52 + 0 . 12 + 0.25 50 2 d1 = = 0.5365 0.3 0.25 32 ln 52 + 0.12 0.2 0.25 50 d2 = = 0.3865, 0.3 0.25 and, therefore, ln
S0 K

c = 52N (0.5365) 50e0.120.25 N (0.3865) Z 0.5365 Z 0.3865 2 x2 1 1 x 0 . 12 0 . 25 = 52 e 2 dx 50e e 2 dx 2 2 0.03 = 52 0.7042 50e 0.6504 = $5.06. 13.17 With the notation used in this chapter: (a) What is N 0 (x)? Since N (x) is the cumulative probability that a variable with a standardized normal distribution will be less than x, N 0 (x) is the probability density function for a standardized normal distribution, i.e. x2 1 N 0 (x) = e 2 . 2 0 r(T t) 0 (b) Show that SN (d1 ) = Ke N (d2 ), where S is the stock price at time t and 2 S ln K + r + 2 (T t) d1 = T t S 2 ln K + r 2 (T t) d2 = . T t 4

 SN 0 (d1 ) = SN 0 (d2 + T t) 2 S d 1 = exp 2 d2 T t 2 (T t) 2 2 2 1 = SN 0 (d2 ) exp d2 T t 2 (T t) 2 S 2 1 0 = SN (d2 ) exp ln r (T t) 2 (T t) K 2 2 K = SN 0 (d2 ) er(T t) S r(T t) 0 = Ke N (d2 ). (c) Calculate
d1 S

and

d2 . S K 1 K d1 1 S = = S T t S T t d2 1 = as well. S S T t

(d) Show that when

c = SN (d1 ) Ker(T t) N (d2 ) it follows that c = rKer(T t) N (d2 ) SN 0 (d1 ) t 2 T t

where c is the price of a call option on a non-dividend-paying stock. c d1 d2 = SN 0 (d1 ) rKer(T t) N (d2 ) Ker(T t) N 0 (d2 ) . t t t Using the result from (b), we obtain c = rKer(T t) N (d2 ) + SN 0 (d1 ) t d1 d2 t t .

Therefore,

d1 d2 d1 d2 = T t = = . t t 2 T t c = rKer(T t) N (d2 ) SN 0 (d1 ) . t 2 T t

c (e) Show that = N (d1 ). S Dierentiating the Black-Scholes formula for the price of a call option with respect to S we obtain d2 c d1 = N (d1 ) + SN 0 (d1 ) Ker(T t) N 0 (d2 ) . S S S

Using that SN 0 (d1 ) = Ker(T t) N (d2 ) from (b) and

d1 S

d2 S

from (c), we obtain

c d2 d2 = N (d1 ) + Ker(T t) N 0 (d2 ) Ker(T t) N 0 (d2 ) S S S = N (d1 ). (f ) Show that c satises the Black-Scholes dierential equation. 2c d1 1 = N 0 (d1 ) = N 0 (d1 ) . 2 S S S T t Substituting the results from (d) and (e) in the left-hand side of the Black-Scholes dierential equation, we obtain 2c c c 1 + rS + 2 S 2 2 = rKe(T t) N (d2 ) SN 0 (d1 ) + rSN (d1 ) t S 2 S 2 T t 1 1 + 2 S 2 N 0 (d1 ) 2 S T t = r SN (d1 ) Ker(T t) N (d2 ) = rc. Therefore, c satises the Black-Scholes dierential equation. (g) Show that c satises the boundary condition for a European call option, i.e. that c = max(S K, 0) as t T . Let us rst consider what happens to d1 and d2 as t T . 2 S ln K + r + 2 (T t) lim d1 = lim tT tT T t 2 S r + T t ln K 2 = lim + lim tT T t tT S 1 = ln lim . t T K T t If S > K , ln
S K

> 0, and
tT

lim d1 = +. lim d2 = +. Z

Similarly, for S > K ,

tT

Then,

1 lim N (d1 ) = lim N (d2 ) = tT tT 2 6

e 2 dx = 1,

x2

and
tT

lim c = S K > 0.

If S < K , ln In this case

S K

< 0 and
tT

lim d1 = lim d2 = .
tT tT

tT

lim N (d1 ) = lim N (d2 ) = 0, lim c = 0.

and
tT

If S = K ,
tT

lim d1 = lim d2 = 0,
tT

and
tT

lim c = SN (0) KN (0) = 0. c max(S K, 0).

Therefore, as t T ,

13.18 Show that the Black-Scholes formulas for call and put options satisfy put-call parity. p + S0 = KerT N (d2 ) S0 N (d1 ) + S0 = KerT N (d2 ) + S0 N (d1 ). Also, c + KerT = S0 N (d1 ) KerT N (d2 ) + KerT = KerT N (d2 ) + S0 N (d1 ).

= KerT N (d2 ) S0 (1 N (d1 )) + S0

= S0 N (d1 ) KerT (1 N (d2 )) + KerT

Therefore, p + S0 = c + KerT , and the Black-Scholes formulas satisfy put-call parity.