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Assignment 3
Winter 2015/16
The following article provides a good, informal introduction into the topic:
Sundaram, R. (1997): Equivalent Martingale Measures and Risk-Neutral Pricing: An
Expository Note, Journal of Derivatives 5, 85-99.
(a) What does the existence of a risk-neutral probability measure tell you? Calculate the
risk-neutral probabilities for the example above.
(b) Define market completeness. Is the market above complete?
(c) Now suppose a consultant approaches the investor. The consultant is confident that the
price of the stock will either be 4000 or 3000. Is the market arbitrage-free and complete?
(d) You believe that the company has some probability of going bankrupt. You suggest that
the stock price next year will be 4000 (state 1), 2000 (state 2) or 0 (state 3). Is the market
complete?
(e) Is it possible to construct a market that is
i. complete and there are no arbitrage opportunities?
ii. complete and there are arbitrage opportunities?
iii. incomplete and there are no arbitrage opportunities?
iv. incomplete and there are arbitrage opportunities?
1
3. Replicating Portfolio
Assume that the current stock price equals 100. Consider a two-period binomial tree with the
following parameters: u = 1.2, d = 0.8, r = 0 (discrete compounding).
(a) Determine the price of a European call option maturing in two years with strike price
100 via the replicating portfolio approach. How many shares does the replicating portfolio
include (at each point in time and in each state). What is the amount invested in the
money market?
(b) What important requirement should the replicating portfolio meet? Explain this require-
ment in general and by using the example from above.
(a) Give the dynamics of the stock price in a three-period binomial tree.
(b) Use this tree to price the following contracts which all mature at T = 3:
i. European call option with strike price K = 60,
ii. American call option with strike price K = 60,
iii. European put option with strike price K = 45,
iv. European put option with strike price K = 60,
v. American put option with strike price K = 45,
vi. Derivative with payoff |S3 60|.