Financial Engineering

MRM 8610, Spring 2016

Homework 1 – Solution Daniel Bauer

Due Thursday, 01/21/2016 before class

1. Black-Scholes formula for European Put (2 points):
Use the Put-Call parity and the Black-Scholes formula for the European call from Proposition 1 to derive a
similar formula for the European put option.
Solution:
We use 1 − Φ(x) = Φ(−x) where Φ(·) is the cdf of the Normal distribution:

P0 = K · e−r T + C0 − S0
= K · e−r T + S0 · Φ (d1 (S0 , t)) − K · e−r T · Φ (d2 (S0 , t)) − S0
= K · e−r T (1 − Φ (d2 (S0 , t))) − S0 (1 − Φ (d1 (S0 , t)))
= K · e−r T · Φ (−d2 (S0 , t)) − S0 · Φ (−d1 (S0 , t))

2. Hedging a long position:

Consider a bank that has a long position in a European Put written on the stock price in a one period binomial
model with u = 2, v = 21 , S = S0 = 4, and r = 16 1
. The Put expires at time T = 1 and has strike price K = 3.
At time zero, the bank owns this option, which ties up capital V0 . The bank wants to earn the interest rate 6.25%
on this capital until time one (i.e. “no matter what the markets do”, the bank wants to have 1.0625 · V0 at time
one). Specify how the bank’s trader should invest in the stock and money markets to accomplish this.
Solution:
1+r−d 3 1 10
We have q = u−v = 8 and V0 = 1+r (0 q + 1 (1 − q)) = 17 .
Let ∆ denote the amount of stock, and B the amount in the money market account. And time one, we want:
10 5
0 + ∆ · 8 + 1.0625 · B = ⇐⇒ 0 + ∆ · 8 = −1.0625 · B +
1.0625
17 8
10 5
1 + ∆ · 2 + 1.0625 · B = 1.0625 ⇐⇒ 1 + ∆ · 2 = −1.0625 · B +
17 8
⇒ −1 + ∆ · (8 − 2) = 0
5
∆ · 8 + 1.0625 · B =
8
1
⇒∆ =
6
2
B = −
3
So, the appropriate strategy is: long 1/6 stock and borrow $ 32 in the money market.
3. Lookback option:
Suppose as in the Excel-File a three-period binomial model with u = 2, v = 12 , S0 = 4, and r = 1
16 . Consider
a lookback option that pays off
V3 = max Sn − S3
0≤n≤3

at time three. Compute

(a) V0 and ∆0 ;
(b) V1 and ∆1 .
MRM 8610 Financial Engineering 2

(Solution see Excel File)

4. American Puts, Calls, and Straddles:
Suppose as in the Excel-File a three-period binomial model with u = 2, v = 21 , S0 = 4, and r = 1
16 .

(a) Determine the price at time zero, denoted V0P , of the American put that expires at time three and has
intrinsic value gP (s) = (4 − s)+ .
(b) Determine the price at time zero, denoted V0C , of the American call that expires at time three and has
intrinsic value gC (s) = (s − 4)+ .
(c) Determine the price at time zero, denoted V0S , of the American straddle that expires at time three and has
intrinsic value gS (s) = gP (s) + gC (s).
(d) Explain why it is possible that V0S < V0P + V0C .
(Solution see Excel File)