Semester I, 2013; MAL732: Practice Problems Sheet 3 Binomial Model and Black-Scholes Model 1.

Let the current stock price be 120 and there are only two possibilities of its change: go up by 25% with probability 70% or down by 20%. Assume the risk free rate is 5% for one period. (a) (b) (c) (d) What is the expected stock price and return on stock in next period? Answer the same questions if the up-down movement follows risk neutral probability. Find the call price and put price on same underlying stock with strike price 130. Create a synthetic call and a synthetic put (against (c)) using appropriate position in the underlying stock and risk-free asset.

2. The current share price is 85, risk free rate is 6% per annum continuously compounded and volatility is 25% per annum. Construct a binomial tree and use it to value a two month European 90-call. 3. The current share price is 100, the risk free rate is 5% continuously compounded, and volatility 30% per annum. Construct a binomial tree and use it to value a one month European 80-put. 4. Consider a one period binomial model with S (0) = 100, r = 0.08, = 30%. (a) Compute American put option value with K = 100, 110, 120. (b) At what strike(s) the early exercise occur (if any)? (c) Use put-call parity to explain why early exercise is sure to occur for all strikes greater than your answer in (b). 5. Suppose that S 90) = 100, K = 45, = 0.3, r = 0.08 continuously compounded. The stock will pay a dividend 4 in exactly month from present time. (a) Compute the price of European and American call options using 2-period binomial model. (b) Are the two prices same? (c) Do you note any dierence between two types of call options vis a vis underlying stock paying dividend or not in between investment period. 6. Let S (0) = 100, K = 120, = 30%, r = 0.08. Compute the Black-Scholes call price for maturity 1 year, 2 years, and comment on what happens to option price when T ? 7. Maria wishes to purchase 204 European call options on the stock of BHARTI AIRTEL. The stock currently trades for 400 per share, and pays dividends at an annual continuously-compounded yield of 0.11. The annual continuously-compounded risk-free interest rate is 0.09, and the relevant measure of volatility is 0.1. The strike price of the options is 430, and the options will expire in 3 years. Use the Black-Scholes formula to nd the price of the block of 100 call options. 8. The stock of APPLE does not pay dividends. The stock currently trades for 5500 per share, with price volatility of 0.21. The annual continuously-compounded risk-free interest rate is 0.02. Use the Black-Scholes formula to nd the price of a put option on APPLE stock with a strike price of 5430 and time to expiration of 1 year. 9. Suppose S (0) = 100, K = 95, = 30%, r = 0.08, = 0.03, T = 0.75. (a) Compute the Black-Scholes price of a call. (b) Compute Black-Scholes price of call for which S (0) = 100e0.030.75 , K = 95e0.080.75 , = 30%, r = 0, = 0, T = 0.75. How is your answer compare to (a)? 10. Assume K = 40, = 30%, r = 0.08, T = 0.5, and the stock pays a single dividend of 2 tomorrow, with no dividend thereafter. (a) If S (0) = 50, then what is the value of European call on stock? (b) If S (0) = 50, then what is the value of American call option on stock? (c) Repeat (b) with S (0) = 60. Under what circumstances (if any) would you not exercise the American option today itself?