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Derivatives I

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.

1. Arbitrage and Completeness

Suppose that the current price of the Fair Price stock is 2500. An investor believes that next
year the stock price will be either 4000 (state 1) or 2000 (state 2). There exists a riskless cash
bond and the risk-free rate is zero.

(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
(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?

2. Risk Neutral Probabilities and Arbitrage Strategy

Assume that the current stock price S0 equals 125 and that it is known that it will be either
144 or 100 in four months (so you will use a one-period binomial model). The risk-free interest
rate equals 8% p.a. (continuous compounding).

(a) Calculate the risk-neutral probabilities.

(b) Use risk-neutral
 to value a derivative maturing in four months whose payoff is
given by max ST , 11 .
(c) Assume that the market price of the derivative equals 10.5. Explain the strategy you would
apply to lock in arbitrage profits. Give the exact positions you would take (in the stock,
the money market account, and the derivative) as well as the resulting payments today
and at maturity.

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.

4. American and European Options

Assume that the current stock price equals 50 and that the following parameters are given:
u = 1.1, d = 0.9, r = 0.07 p.a. (discrete compounding).

(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|.