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Black-Scholes-Merton

Option Pricing Model

1. A Markov process is a particular type of stochastic process where only relevant for predicting the future.

2. The stochastic process usually assumed for a stock price is

.

is

3. Stochastic processes can be classiﬁed as

classiﬁed as

or

.

or

,

and can also be

4. The expected value of the change of the variable during the per-unit time of stochastic process is called , and the variance of the change is called .

5. Deﬁne µ as expected on stock and σ as volatility of the stock price,so that δS

.

6. Consider a stock where the current price is \$20,the expected return is 20% per an- num,and the volatility is 40% per annum.The expected stock price in one year,E(S T ) is ,and the variance of the stock price in one year,var(S T ) is .

7. The volatility of a stock price is 30% per annum the standard deviation of the

percentage price change in one trading day is

.

8. In this case =0.15 and σ = 0.25,the probability distribution for the rate of return

over a 2-year period with continuous compounding is

.

9. In the case c=2.5, S 0 = 15 K=13,T=0.25,r=0.05,the implied volatility is

.

10. Consider a three-month European put option on a non-dividend-paying stock with a strike price of \$50,when the current stock is \$50,the risk-free interest rate is 10%

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2

BLACK-SCHOLES-MERTON OPTION PRICING MODEL

per annum,and the volatility is 30% per annum.so the price of the put option is

.

11. Consider a three-month European put option on a dividend-paying stock with a dividend of \$1.50 expected in two months and its strike price is \$50,when the current stock is \$50,the risk-free interest rate is 10% per annum,and the volatility is 30% per annum.so the price of the put option is .

12. A stock price follows geometric Brownian motion with an expected return of 16% and a volatility of 35%. The current price is \$38.The probability that a European call option on the stock with an exercise price of \$40 and a maturity date in six months will be exercised is .

13. A stock price follows geometric Brownian motion with an expected return of 16%

and a volatility of 35%. The current price is \$38.The probability that a European put option on the stock with an exercise price of \$40 and maturity will be exercised

is

.

14. Consider a European put option on a non-dividend-paying 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 three months.The price of the put option is

.

15. Calculate the delta of an at-the-money six-month European call option on a non- dividend-paying stock when the risk-free interest rate is10%per annum and the stock price volatility is 50%per annum, the delta is .

16. The options mature in eight months, and the futures contract underlying the option matures in nine months. The current nine-month futures price is \$8 per ounce, the exercise price of the option is\$8, the risk-free interest rate is 12% per annum, and the volatility of silver is 18% per annum,the delta of a short position in 1,000 European call options on silver futures is .

17. Consider the option with hedging using the currency requires a short position of \$458,000.So hedging using nine-month currency futures requires a short futures po- sition of \$

.

18. Consider a four-month put option on a stock index.The current value of the index is 305,the strike price is 300,the dividend yield is 3% per annum,the risk-free interest

3

19.

20.

21.

22.

rate is 8% per annum,and the volatility of the index is 25% per annum.The option’s

theta is

per calendar day.

Suppose that a delta-neutral portfolio has a gamma equal to Γ,and a traded option

has a gamma equal to Γ T .If the number of traded options added to the portfolio is

ω T ,the gamma of the portfolio is

.

Suppose that a portfolio is delta neutral and has a gamma of -3,000.The delta and gamma of a particular traded call option are 0.62 and 1.50,respectively.The delta of

the portfolio will then change from zero to

.

Consider a four-month put option on a stock index.The current value of the index is 305,the strike price is 300,the dividend yield is 3% per annum,the risk-free interest rate is 8%per annum,and volatility of the index is 25% per annum.The gamma of the index option is .

A U.S bank has sold six-month put option on £1 million with a strike price of 1.6000

and wishes to make its portfolio delta neutral.Suppose that the current exchange rate is 1.6200,the risk-free interest rate in the United Kingdom is 13% per annum, the risk-free interest rate in the United States is 10% per annum,and the volatility of sterling is 15%.So the delta of a put option on a currency is .

( )

1. The Markov property of stock prices is consistent with the

(

)

 A. strong-form market eﬃciency B. weak-form market eﬃciency C. semi-strong-form market eﬃciency D. the above options are all correct

2. Suppose we want to simulate price paths for a stock with a beginning value of \$1,000,

a mean of 0(µ = 0forS ), and a standard deviation of 20% over our investment

horizon of 100 days. Using Monte Carlo simulation, the stock price at the ﬁrst day

 is ( ) A. \$1002.56 B. \$1001.28 C. \$997.44 D. \$994.88

3. How should a geometric Brownian motion model be adapted for use in Monte Carlo

4

BLACK-SCHOLES-MERTON OPTION PRICING MODEL

A. Use a binomial probability distribution.

B. Assume stock returns cannot be negative.

C. Extend the investment horizon to a minimum of one year.

D. Divide the investment horizon into small, discrete intervals.

4. Consider a stock whose price is S.In a short period of time of length t, the return

)

on the stock is normally distributed

(

 A. S ∼ (µδt, σ 2 δt) B. δS ∼ (µδt, σ 2 δt) C. δS/S ∼ (µt, σ 2 δt) D. S/δS ∼ (µδt, σ 2 δt)

5. For the lognormal distribution,its expected value,E(S T ) = S 0 e µT ,so the variance,var(S T ) = )

(

A.

C.

2

0

2

0

S

S

e 2µT

e 2µT (1 e σ 2 T )

B. S

e 2µT (e σ 2 T 1)

D. S 0 e 2µT (e σ 2 T 1)

2

0

6. The lognormal property of stock prices can be used to provide information on the probability distribution of the continuously compounded rate of return earned on a stock between times zero and T.Deﬁne the continuously compounded rate of return

per annum realized between times zero and T as η.It follows that S T = S 0 e ηT ,so that

η =

T ln S T ,so η

1

S

0

A.

C. φ(µ,

φ( σ 2

T )

σ

T )

σ

2

,

7. The expected return on the

B. φ(µ σ 2 2 , T )

D. φ(µ σ 2

σ

T )

σ

2

,

stock is µ σ 2 /2,

= µ σ 2 /2

(

(

)

)

 A. E(lnS T /S 0 ) B. ln[E(S T /S 0 )] C. E(S T /S 0 ) D. ln(S T /S 0 )

8. In a forward contract the boundary condition is

when t =T,

(

)

 A. f = S B. f = S − Ke −r (T − t) C. f = Ke −r (T − t) D. f = S − K

9. The Black-Scholes Formulas is

A. c = S 0 N(d 1 ) Ke r N(d 2 ), p = B.

Ke r N(d 2 ) S 0 N(d 1 )

C.

Ke r N(d 2 ) S 0 N(d 1 )

= D.

c = Ke r N(d 2 ) S 0 N(d 1 ), p =

=

S 0 N(d 1 ) Ke r N(d 2 )

c

=

c

=

S 0 N(d 1 ) Ke r N(d 2 ), p

S 0 N(d 2 ) Ke r N(d 1 ), p

Ke r N(d 2 ) S 0 N(d 1 )

(

)

5

A.

C.

ln(S/X)+(r+σ 2 /2)(T t)

σ Tt

ln(S/X)+(σ 2 /2)(T t)

σ Tt

B.

D.

ln(S/X)(σ 2 /2)(T t)

σ Tt

ln(S/X)+(rσ 2 /2)(T t)

σ Tt

 11. An American call option with dividends cannot be exercised when ,we as- sume that n ex-dividend dates are anticipated and that t 1 < t 2 < t 3 < < t n .The

dividends corresponding to these times will be denoted by D 1 , D 2 ,

B. D i K(1 e r(t i+1 t i ) ) D. D i K(1 e rt i )

A.

C. D i

D i K(1 e r(t i+1 t i ) )

K(1 e r(t i+1 t i ) )

, D n ,respectively. (

)

12. This involves maintaining a delta neutral portfolio,the delta of a European call on a

stock paying dividends at rate q ise qT N(d 1 ), The delta of a European put is (

)

 A. e −qT N(d 1 ) B. e −qT [1 − N (d 1 )] C. e −qT [N(d 1 ) − 1] D. e −qT N(d 1 ) − 1

13. The position required in futures for delta hedging is therefore position required in the corresponding spot contract.

A.

C.

 e −(r−q)T B. e (r−q)T −e (r−q)T D. e −(q−r)T

times the

)

(

14. Traders usually ensure that their portfolios are delta-neutral at least once a day,

 whenever the opportunity arises, they improve gamma and . ( ) A. delta B. theta C. rho D. vega 15. Stop-Loss Strategy: 100,000 shares as soon as price reaches \$50, 100,000 shares as soon as price falls below \$50. ( )

16. Consider a stop-loss strategy,the initial stock price is S 0 ,so the cost of setting up the hedge initially is S 0 if S 0 > K and zero otherwise.So the total cost of writing and

 hedging the option,Q, is the option’s intrinsic value,that is ( ) A. Q = max(S 0 − K, 0) B. Q = min(S 0 − K, 0) D. Q = min(K − S 0 , 0) C. Q = max(K − S 0 , 0) 17. For a European put option on a non-dividend-paying stock,∆ = . ( )
 A. N (d 1 ) B. 1 − N (d 1 ) C. N (d 1 ) − 1 D. N (d 1 ) + 1

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BLACK-SCHOLES-MERTON OPTION PRICING MODEL

18. Suppose that δS is the price change of an underlying asset during a small interval of time,δt,and δΠ is the corresponding price change in the portfolio.If terms of higher

order than δt are ignored,for a delta-neutral portfolio,βΠ =

A.

C.

Θδt + 2 ΓδS

δt + 1

1

B. Θδt + ΓδS 2

D. Θδt + 1

2 ΓδS 2

2 ΓδS 2

.

(

)

19. For a European call or put option on an asset paying a continuous dividend at rate

)

B.

D.

q,Γ =

A.

C.

(

N(d 1 )e qT S 0 σ T N (d 1 )e qT S 0 σ T

N (d 1 )e rT

S 0 σ T

N (d 1 )e rT

S T σ T

20. For a portfolio of derivatives on a stock paying a continuous dividend yield at rate

q.So the relationship among delta, gamma, and theta is

A. Π + rS Π +

1

2

1

2

σS 2 Π

∂S 2

σ 2 S 2 ∂S 2 Π 2

= rΠ

= rΠ

B. Π + rS Π

∂t

∂S

σ 2 S 2 ∂S 2 Π 2

σ 2 S 2 ∂S 2 Π 2

∂t

∂S

+

C. Π + rS Π +

∂t

∂S

D. Π + S Π +

∂t

∂S

1

2

( ×”)

1. Wiener process is a particular type of Markov process.

 ( ) = rΠ = Π ( )

2. A Wiener process, dz, is a process describing the evolution of a normally distributed

)

variable.

(

3. Ito’s lemma is a way of calculating the stochastic process followed by a function of a

variable from the stochastic process followed by the variable itself.

(

)

4. When Markov process are considered, the variance of the changes in successive time

periods are additive, and the standard deviations of the changes in successive time

)

(

5. The price of a stock option is a function of the underlying stock’s price and time. )

(

6. The particular security being valued is determined by the boundary conditions of the

 diﬀerential equation. ( ) 7. The variable does not appear in the Black-Scholes equation. ( )

8. The solution to the diﬀerential equation is not the same in a risk-free world as it is

7

9. Volatility is usually much greater when the market is open (i.e. the asset is trading)

)

than when it is closed.

(

10. Time is usually measured in calendar days not”trading days”when options are valued. (

)

11. The option price and the stock price depend on diﬀerent underlying sources of

 uncertainty. ( ) 12. It is a one-to-one correspondence between prices and implied volatilities. ( ) 13. Traders and brokers often quote dollar prices rather than implied volatilities. ( ) 14. The Black-Scholes equations are consistent with put-call parity. ( )

15. When a regular call option is exercised the stock that is delivered must be purchased

 in the open market. ( ) 16. Stop-Loss Strategy always work well. ( ) 17. Delta Hedging must be frequently rebalanced. ( ) 18. Delta hedging a written option involves a ”buy low, sell high” trading rule. ( )

19. Traders usually ensure that their portfolios are delta-neutral at least once a day, whenever the opportunity arises, they improve gamma and vega. ( )

20. Delta hedging aims to keep the value of the ﬁnancial institution’s position as close

)

unchanged as possible.

(

21. The theta of option,Θ, is the rate of change of the portfolio’s delta with respect to

 the price of the underlying asset. ( ) 22. Theta is usually negative for an option. ( )

23. The gamma of a portfolio of options,Γ,is the rate of change of the value of the portfolio

 with respect to the passage of time. ( ) 24. If gamma is large in absolute term,delta changes slowly. ( )

25. If vega is high in absolute terms,the portfolio’s value is very sensitive to small changes

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BLACK-SCHOLES-MERTON OPTION PRICING MODEL

1. Consider a variable S that follows the process

dS = µdt + σdz

For the ﬁrst three years, µ = 2, σ = 3; for the next three years, µ = 3, σ = 4. If the initial value of the variable is 5, what is the probability distribution of the value of the variable at the end of year 6?

2. A stock price is currently 50. Its expected return and volatility are 12% and 30%, respectively.What is the probability that the stock price will be greater than 80 in two years? (Hint: S T > 80 when ln S T > ln 80.)

3. Suppose that x is the yield to maturity with continuous compounding on a zero- coupon bond that pays oﬀ \$1 at time T. Assume that x follows the process

dx = a(x 0 x)dt + sxdz

where a, x 0 , and s are positive constants and dz is a Wiener process. What is the process followed by the bond price?

4. Calculate the price of a three-month European put option on a non-dividend-paying 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.

5. What is the price of a European call option on a non-dividend-paying stock when the stock price is \$69,the strike price is \$70,,the risk-free interest rate is 5% per annum,the volatility is 35% per annum, and the time to maturity is six months?

6. A ﬁnancial institution has just sold 1,000 seven-month European call options on the Japanese yen.Suppose that the spot exchange rate is 0.80 cents per yen,the exercise price is 0.81 cents per yen,the risk-free rate in the United States is 8% per annum,the risk-free interest rate in Japan is 5% per annum.Calculate the delta of the ﬁnancial institution’s position.

7. Suppose that \$70 billion of equity assets are the subject of portfolio insurance schemes.Assume that the schemes are designed to provide insurance against the value of the assets declining by more than 5% within one year.Making whatever estimates you ﬁnd necessary,use the DerivaGem software to calculate the value of the stock or futures constracts that the administrators of the portfolio insurance schemes will attempt to sell if the market falls by 23% in a single day.

9

1. Markov process

2. Wiener process

3. Ito process

4. volatility

5. implied volatility

6. risk-neutral valuation

7. naked position

8. stop-Loss Strategy

9. scenario Analysis

1. What would it mean to assert that the temperature at a certain place follows a Markov process. Do you think that temperature do, in fact, follow a Markov process?

2. Explain the principle of risk-neutral valuation.

3. What is implied volatility? How can it be calculated?

4. What is meant by the gamma of an option position? What are the risks in the situation where the gamma of a position is large and negative and the delta is zero?

5. The procedure for creating an option position synthetically is the reverse of the procedure for hedging the option position. Explain this statement.