AFC 3140 – Advanced Corporate Finance

Week 07 Tutorial Answers

(1)

Su =$53, fu = 4

up 6%

$50

down 4%

Sd =$48, fd=0

X=$49. At the end of two months the value of the option will be either $4 (if stock price is $53) or $0 (if
the stock price is $48). Consider a portfolio consisting of

+: shares (buy  shares)

-1: call (sell 1 option)

The value of the portfolio is either 48  or 53  – 4 in two months. For the portfolio to be riskless

48  = 53  – 4

solving for  ,  =0.8

the future value of the portfolio is $48(0.8) = $53(0.8) – 4 = $38.40

the value of the portfolio is certain to be $38.40. For the value of  the portfolio is therefore riskless.
The current value of the portfolio is 0.8(50) – f, where f is the value of the option. Since the portfolio
must earn the risk-free rate of interest

(50(0.8) – f)1.1 2/12 = 38.4, ie., f = 2.23. ( future value is used here, present value can also be used)

The value of the option is therefore $2.23.

(2) Consider a portfolio consisting of

: shares

-1: short 1 put (value f)

At time 0, the value of the portfolio is 40  - f

The value of the portfolio is either 35  - 5 or 45  at expiry.

For the portfolio to be riskless, the portfolio must have the same value after 3 months.

So … 35  - 5 = 45  , Solving we have  = -0.5 (the negative indicates that we go short on the shares at
time 0)

The value of the portfolio is certain to be 35(-0.5) - 5 = 45(-0.5) = -22.5

For a portfolio to be riskless it must earn the risk free rate of return, so …

(40(-0.5) - f)(1.02) = -22.5 Hence, f = 2.06, ie., the value of the put option is $2.06.

This can also be calculated using risk-neutral valuation. Suppose p is the probability of an upward stock
price movement in a risk-neutral world, and since risk-free interest rate is 8% compounded quarterly,
we must have

45p + 35(1 – p) = 40(1.02) or p= 0.58

The expected value of the option in a risk-neutral world is [0(0.58) + 5(0.42)]/1.02 = 2.06. This is
consistent with the no-arbitrage answer.
(3)

Because the risk-free interest rate is not quoted with continuous compounding, the appropriate version
of the Black-Scholes equation is:

ln S 
 PV ( X )   T
d1   T  2

d 2
 d1   T

The values of the variables in the equation are:

Current share price: S = $25.00

Exercise price: X = $24.50

Term to expiry: T = 1 year

Volatility (variance): σ2 = 0.0625 per annum

Standard deviation: σ = 0.25 per annum

Risk-free interest rate: r = 6 per cent per annum

The first task is to calculate the present value of the exercise price:

PV  X  
$24.50
1.06
 $23.11

The next task is to calculate d1 and d2:

n($25.00 / $23.11)  0.25 1

d1 
0.25 1 2
 0.4389
d 2  0.4389  0.25 1
 0.1889
Consulting the table of values for the standard normal distribution N(.), or by using the Excel
NORMSDIST function, we find that:

N (d1 )  N (0.4389)  0.6696 and

N (d 2 )  N (0.1889)  0.5749

Substituting

c  S N (d1 )  PVX N (d 2 )
 ($25.00) (0.6696)  ($23.11) (0.5749)
 $3.45
(4) using the put – call parity

c  PV ( X )  p  S

So 3.45  23.11  p  25

p  $1.57

(5) First calculate the present value of the dividend

1.50
PV (div)   $1.48
1.06 0.2 5

The dividend adjusted stock price is then S *  $25  $1.48  $23.52

Then use dividend adjusted stock price keeping all other variables the same as in question 3.

PV  X  
$24.50
 $23.11
1.06

The next task is to calculate d1 and d2:

n($23.52 / $23.11)  0.25 1

d1 
0.25 1 2
 0.1951
d 2  0.1951  0.25 1
 0.0549

Consulting the table of values for the standard normal distribution N(.), or by using the Excel
NORMSDIST function, we find that:

N (d1 )  N (0.1951)  0.5773 and

N (d 2 )  N (0.0549)  0.4781

Substituting

c  S * N (d1 )  PVX N (d 2 )
 ($23.52) (0.5773)  ($23.11) (0.4781)
 $2.53