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Answer key to Homework 3

1) a) (3 pts) Applying the formula for bounds of American put, we have


max{0, S(0) + X} P A < X
max{0, 100 + 110} P A < 110
thus 10 P A < 110.

b) (3 pts) Since no-dividend is paid, C A = C E . Applying the formula for bounds of American call,
we have
max{S(0) XerT , 0} C E (= C A ) < S(0)
max{0, 100 110e0.072 } C E < 100
thus 4.37 C E < 100
Thus $6 is an appropriate price for the European call.

c) (4 pts) Since the stock pays no dividend, C A = C E = 6. Applying the Put-Call Parity
Estimates (for American call and put), we get
S(0) XerT C A P A S(0) X
S(0) XerT C A P A S(0) X C A
S(0) + XerT + C A P A S(0) + X + C A
100 + 110e0.072 + 6 P A 100 + 110 + 6
1.63 P A 16.
which together with the result of part a) implies that
10 P A 16.

2) a) (5 pts) Directly apply Put-call parity estimate for American options:


S(0) XerT C A P A S(0) X
S(0) XerT C A P A S(0) X C A
S(0) + XerT + C A P A S(0) + X + C A
60 + 65e0.052 + 2 P A 60 + 65 + 2
0.81 P A 7.
Hence, $8 is an overestimated price for this American put.

b) (5 pts) The dividend paying date t = 1, so div0 = divert = 2e0.051 = 1.90. Apply Put-call
parity estimate of dividend case
S(0) XerT C A P A S(0) div0 X
S(0) + XerT + C A P A S(0) + div0 + X + C A
60 + 65e0.052 + 2 P A 60 + 1.90 + 65 + 2
0.81 P A 8.9

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Hence, $8 is an appropriate price for this American put.

3) (15 pts) We know from the Put-Call Parity Estimates that

S(0) XerT C A P A S(0) div0 X. (0.1)

In this question, S(0) XerT = 85 80e0.08 = 11.15,


C A P A = 5 8 = 3,
1
S(0) div0 X = 85 7e0.08 4 80 = 1.73

Clearly, the second in (0.1) does not hold, i.e. we virtually have

C A P A < S(0) div0 X C A + div0 + X < S(0) + P A

To obtain an arbitrage, we can start from $0 today to take the following transactions:
a) buy an American call for $5 ;

b) sell an American put for $8 ;

c) short sell one share for $85 ;

d) deposit the proceeds 85 + 8 5 = 88 dollars .

Case 1): If the American put is exercised at time t < 12 by the other party. At time t, we have to buy
one share from him for $80 dollars. To finance this purchase,

e) we borrow $80 dollars at time t .

Then we return this share to the lender to close c). Since t is before the dividend paying time 21 ,
we do not need to pay the lender the dividend . Thus transaction b) and c) is replaced by e).
At time 1, we end up with the American call (whose payoff is always nonnegative) and the sum
of transaction d), e) is

88e0.08 80e0.08(1t) > 88e0.08 80e0.08 = 8.67 > 0

Case 2): If the American put is exercised at time t [ 12 , 1] by the other party , we first have to pay
the dividend 7 to the lender at time 21 by
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e) borrowing $7 dollars at time 2 .

Then at time t, we have to buy one share from him for 80 dollars. To finance this purchase,
f) we borrow 80 dollars at time t .

Then we return this share to the lender to close c). Thus transaction b) and c) is replaced by
f).
At time T = 1, we end up with the American call (whose payoff is always nonnegative) and
transaction d), e) , f) with value
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88e0.08 7e0.08(1 2 ) 80e0.08(1t)
> 88e0.08 7e0.08 80e0.08 = e0.08 > 0

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Case 3): If the American put is not exercised at all. We first have to pay the dividend $7 to the lender
at time 12 by
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e) borrow $7 dollars at time 2 .

At time 1, we exercise our American call: we buy one share to close c) by borrowing 80 dollars,
which together with transaction d), e) gives rise to our total wealth at time T :
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80 7e0.08(1 2 ) + 88e0.08
> 80 7e0.08 + 88e0.08 > 80 + 81e0.08 > 0

All cases will bring us a positive profit, which is an arbitrage.

4) (10 pts) The equality X3 X2 = 2(X2 X1 ) can be reformed as

2 1
X2 = X1 + X3
3 3
Since all option prices are convex function with respect to the strike price X , we have
2 1 2 1 2 1
c2 = C E (K2 ) = C E ( K1 + K3 ) C E (K1 ) + C E (K3 ) = c1 + c3
3 3 3 3 3 3
2 1 22
= 9+ 4= = 7.33
3 3 3
Hence c2 can not equal 8.

5) a) (5 pts) S(2) has three different values S uu = S(0)(1+u)2 = 132.25, S ud = S(0)(1+u)(1+d) =


103.5, S dd = S(0)(1 + d)2 = 81. The payoff function of European put is f (S) = max{X S, 0}, so
f (suu ) = 0, f (sud ) = 1.5, f (sdd ) = 24.
rd 0.2
The risk-neutral probability p = ud = 0.25 = 0.8 .

1
P E (0) =
 
2
E f (S(2))
(1 + r)
1 h
= p2 f (suu ) + 2p (1 p )f (sud )
(1 + r)2
i
+(1 p )2 f (sdd )
1 h i
= 0.64 0 + 0.32 1.5 + 0.04 24
(1 + 0.1)2
= 1.19

b) (10 pts) We let

(x(1), y(1)) be the part of the replicating strategy in the root branch;

(xu (2), y u (2)) and (xd (2), y d (2)) be the part of the replicating strategy in the upper and lower
branch respectively.

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1) [at the upper branch]: Since the replicating strategy at this branch provides the same payoff
as the European put at T = 2, we have
(
xu (2) S uu + y u (2) (1 + r) = f (S uu );
xu (2) S ud + y u (2) (1 + r) = f (S ud ).

It is easy to solve this system:

f (S uu ) f (S ud )

0 1.5
xu (2) = = = 0.05217;


() S(0)(1 + u)(u d) 100 1.15 0.25
uu
(1 + d)f (S ) (1 + u)f (S ) ud
y u (2) = = 6.2727.


(u d)(1 + r)

The upper value of the European put at t = 1 is

PuE (1) = xu (2)S u + y u (2) = 0.2732

2) [at the lower branch]: Similar to (**), we get

f (S ud ) f (S dd )

xd (2) = = 1;


S(0)(1 + d)(u d)
(1 + d)f (S ud ) (1 + u)f (S dd )
y d (2) = = 95.4545.


(u d)(1 + r)

Hence the lower value of the European put at t = 1 is

PdE (1) = xd (2)S d + y d (2) = 5.4545

3) [at the root branch]: Since the replicating strategy at this branch provides the same value as
the European put at t = 1, we have
(
x(1) S u + y(1) (1 + r) = PuE (1) (NOT f (S u ));
x(1) S d + y(1) (1 + r) = PdE (1) (NOT f (S d )).

It solves:
P E (1) PdE (1)

x(1) = u = 0.2073;


S(0)(u d)
(1 + d)PuE (1) (1 + u)PdE (1)
y(1) =

= 21.916.
(u d)(1 + r)

Therefore, P E (0) = x(1)S(0) + y(1) = 0.2073 100 21.916 = 1.19, exactly as we calculate
in part a).