ECO764A: Financial Econometrics

Practice Set
Reference Book: J C Hull, 10th edition
Chapters: 10, 11, 12, 13 and 15

1. The price that the buyer of a call option pays to acquire the option is called the
A. strike price.
B. exercise price.
C. execution price.
D. acquisition price.
E. premium.

The price that the buyer of a call option pays to acquire the option is called the premium.

2. The current market price of a share of AT&T stock is $50. If a call option on this stock
has a strike price of $45, the call
a. is out of the money.
b. is in the money.
c. sells for a higher price than if the market price of AT&T stock is $40.
d. is out of the money and sells for a higher price than if the market price of AT&T
stock is $40.
e. is in the money and sells for a higher price than if the market price of AT&T
stock is $40.

If the striking price on a call option is less than the market price, the option is in the
money and sells for more than an out of the money option.

3. The current market price of a share of Boeing stock is $75. If a call option on this stock
has a strike price of $70, the call
a. is out of the money.
b. is in the money.
c. sells for a higher price than if the market price of Boeing stock is $70.
d. is out of the money and sells for a higher price than if the market price of Boeing
stock is $70.
e. is in the money and sells for a higher price than if the market price of Boeing
stock is $70.
If the striking price on a put option is less than the market price, the option is out of the
money and sells for less than an at the money option.

4. Buyers of put options anticipate the value of the underlying asset will __________ and
sellers of call options anticipate the value of the underlying asset will ________.

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 a. increase; increase
b. decrease; increase
c. increase; decrease
d. decrease; decrease
e. Cannot tell without further information
The buyer of the put option hopes the price will fall in order to exercise the option and sell the
stock at a price higher than the market price. Likewise, the seller of the call option hopes the
price will decrease so the option will expire worthless.

5. Suppose the price of a share of Google stock is $500. An April call option on Google
stock has a premium of $5 and an exercise price of $500. Ignoring commissions, the
holder of the call option will earn a profit if the price of the share
a. increases to $504.
b. decreases to $490.
c. increases to $506.
d. decreases to $496.
e. None of the options
$500 + $5 = $505 (breakeven). The price of the stock must increase to above $505 for the
option holder to earn a profit.
6. Suppose the price of a share of IBM stock is $200. An April call option on IBM stock has
a premium of $5 and an exercise price of $200. Ignoring commissions, the holder of the
call option will earn a profit if the price of the share
a. increases to $204.
b. decreases to $190.
c. increases to $206.
d. decreases to $196.
e. None of the options
$200 + $5 = $205 (breakeven). The price of the stock must increase to above $205 for the
option holder to earn a profit.

7. You purchased one AT&T March 50 put and sold one AT&T April 50 put. Your strategy
is known as
a. a vertical spread.
b. a straddle.
c. a time spread.
d. a collar.
A time spread involves the simultaneous purchase and sale of options with different
expiration dates, same exercise price.

8. Before expiration, the time value of a call option is equal to

a. zero.
b. the actual call price minus the intrinsic value of the call.
c. the intrinsic value of the call.

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 d. the actual call price plus the intrinsic value of the call.
The difference between the actual call price and the intrinsic value is the time value of the
option, which should not be confused with the time value of money. The option's time
value is the difference between the option's price and the value of the option were the
option expiring immediately.

9. You buy one Home Depot June 60 call contract and one June 60 put contract. The call
premium is $5 and the put premium is $3. Your strategy is called
a. a short straddle.
b. a long straddle.
c. a horizontal straddle.
d. a covered call.
e. None of the options
Buying both a put and a call, each with the same expiration date and exercise price, is a
long straddle.

10. The put-call parity theorem

a. represents the proper relationship between put and call prices.
b. allows for arbitrage opportunities if violated.
c. may be violated by small amounts, but not enough to earn arbitrage profits, once
transaction costs are considered.
d. All of the options
e. None of the options
The put-call parity relationship states the relationship between put and call prices, which,
if violated, allows for arbitrage profits; however, these profits may disappear once
transaction costs are considered.

11. HighFlyer Stock currently sells for $48. A one-year call option with strike price of $55
sells for $9, and the risk-free interest rate is 6%. What is the price of a one-year put with
strike price of $55?
a. $9.00
b. $12.89
c. $16.00
d. $18.72
e. $15.60
P = 9 - 48 + 55/(1.06); P = 12.89.

12. Consider a one-year maturity call option and a one-year put option on the same stock,
both with striking price $45. If the risk-free rate is 4%, the stock price is $48, and the put
sells for $1.50, what should be the price of the call?
a. $4.38
b. $5.60
c. $6.23

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 d. $12.26
e. None of the options
C = 48 - [45/(1.04)] + 1.50; C = $6.23.

13. You purchased a call option for $3.45 17 days ago. The call has a strike price of $45 and
the stock is now trading for $51. If you exercise the call today, what will be your holding
period return? If you do not exercise the call today and it expires, what will be your
holding period return?
a. 173.9%, -100%
b. 73.9%, -100%
c. 57.5%, -173.9%
d. 73.9%, -57.5%
e. 100%, -100%
If the call is exercised the gross profit is $51 - 45 = $6. The net profit is $6 - 3.45 = $2.55.
The holding period return is $2.55/$3.45 = .739 (73.9%). If the call is not exercised, there
is no gross profit and the investor loses the full amount of the premium. The return is ($0
- 3.45)/$3.45 = -1.00 (-100%).

14. Suppose that you purchased a call option on the S&P 100 Index. The option has an
exercise price of 1,700 and the index is now at 1,760. What will happen when you
exercise the option?
a. You will have to pay $6,000.
b. You will receive $6,000.
c. You will receive $1,700.
d. You will receive $1,760.
e. You will have to pay $7,000.
When an index option is exercised, the writer of the option pays cash to the option holder.
The amount of cash equals the difference between the exercise price of the option and the
value of the index. In this case, you will receive 1,760 - 1,700 = 60 times the $100
multiplier, or $6,000. In other words, you are implicitly buying the index for 1,700 and
selling it to the call writer for 1,760.

15. Compute the lowest possible price for 4-month American and European 65 puts on a
stock that is trading at 63 when the risk-free rate is 5%

Answer: American put: P0  max[0, K − S0 ] = max[0, 2] = $2

K
European put: P0  max[0, − S0 ] = max[0,65 / (1.05) ^0.333 − 63] = $0.95
(1 + RFR )T
16. Compute the lowest possible price for 3-month American and European 65 calls on a
stock that is trading at 68 when the risk-free rate is 5%.

Answer:
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 C0  max[0, S0 − K/ (1 + RFR)T ] = max[0,68 − 65 /1.050.25 ] = $3.79
c0  max[0, S0 − K/ (1 + RFR)T ] = max[0,68 − 65 /1.050.25 ] = $3.79

17. Suppose that the current stock price is $52, and the risk-free rate is 5%. You have found a
quote for a 3-month put option with an exercise price of $50. The put is $1.50, but due to
light trading in the call options, there was not a listed quote for the 3-month, $50 call.
Estimate the price of the 3-month call option

Answer: re-arranging put-call parity, we find that the call price is:
Call = put + stock – present value (X)
Call = $1.50 + 52 - $50 e0.05*0.25 = $4.11
This means that if a 3-month, $50 call is available, it should be priced at $4.11 per share.
18. A stock is selling at $40, a 3-month put at $50 is selling for $11, a 3-month call at $50 is
selling for $1, and the risk-free rate is 6%. How much, if anything, can be made on an
arbitrage?
a. $ (no arbitrage)
b. $0.28
c. $0.72
d. None of the above
A synthetic stock is: S = C − P + K / (1 + RFR)T ,$1 − 11 + 50 / (1.06)0.25 = $39.28 . Since the
stock is selling for $40, you can short a share of stock for $40 and buy the synthetic for an immediate
profit of $0.72.

19. Use the Black-Scholes Option Pricing Model for the following problem. Given: SO= $70; X =
$70; T = 70 days; r = 0.06 annually (0.0001648 daily);  = 0.020506 (daily). No dividends will
be paid before option expires. The value of the call option is _______.
A. $10.16
B. $5.16
C. $0.00
D. $2.16
E. None of these is correct

d2 = 0.1530277 - (0.020506) (70)1/2 = -0.01853781; N(d1) = 0.5600; N(d2) = 0.4919;

C = 0.5600($70) - $70[e-(0.0001648) (70)]0.4919 = $5.16.

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20. Suppose that a European call option to buy a share for $100.00 costs $5.00 and is held
until maturity. Under what circumstances will the holder of the option make a profit?
Under what circumstances will the option be exercised? Draw a diagram illustrating how
the profit from a long position in the option depends on the stock price at maturity of the
option.
Answer:

Ignoring the time value of money, the holder of the option will make a profit if the stock
price at maturity of the option is greater than $105. This is because the payoff to the
holder of the option is, in these circumstances, greater than the $5 paid for the option.
The option will be exercised if the stock price at maturity is greater than $100. Note that
if the stock price is between $100 and $105 the option is exercised, but the holder of the
option takes a loss overall. The profit from a long position is as shown below:

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 21. Suppose that a European put option to sell a share for $60 costs $8 and is held until
maturity. Under what circumstances will the seller of the option (the party with the short
position) make a profit? Under what circumstances will the option be exercised? Draw a
diagram illustrating how the profit from a short position in the option depends on the
stock price at maturity of the option:
Answer:
Ignoring the time value of money, the seller of the option will make a profit if the stock
price at maturity is greater than $52.00. This is because the cost to the seller of the option
is in these circumstances less than the price received for the option. The option will be
exercised if the stock price at maturity is less than $60.00. Note that if the stock price is
between $52.00 and $60.00 the seller of the option makes a profit even though the option
is exercised. The profit from the short position is as shown below:

22. Describe the terminal value of the following portfolio: a newly entered-into long forward
contract on an asset and a long position in a European put option on the asset with the same
maturity as the forward contract and a strike price that is equal to the forward price of the
asset at the time the portfolio is set up. Show that the European put option has the same
value as a European call option with the same strike price and maturity.
Answer:
The terminal value of the long forward contract is:

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 ST − F0
where ST is the price of the asset at maturity and F0 is the forward price of the asset at the time the
portfolio is set up. (The delivery price in the forward contract is also F0 .)

The terminal value of the put option is:

max ( F0 − ST  0)
The terminal value of the portfolio is therefore

ST − F0 + max ( F0 − ST  0)
= max (0 ST − F0 ]
This is the same as the terminal value of a European call option with the same maturity as the forward
contract and an exercise price equal to F0 . This result is illustrated below:

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 23. A trader buys a call option with a strike price of $45 and a put option with a strike price of
$40. Both options have the same maturity. The call costs $3 and the put costs $4. Draw a
diagram showing the variation of the trader’s profit with the asset price.
Answer:

The above figures show the variation of the trader’s position with the asset price. We can divide
the alternative asset prices into three ranges:
a) When the asset price less than $40, the put option provides a payoff of 40 − ST and the call
option provides no payoff. The options cost $7 and so the total profit is 33 − ST .
b) When the asset price is between $40 and $45, neither option provides a payoff. There is a net
loss of $7.
c) When the asset price greater than $45, the call option provides a payoff of ST − 45 and the
put option provides no payoff. Taking into account the $7 cost of the options, the total profit
is ST − 52 .
The trader makes a profit (ignoring the time value of money) if the stock price is less than $33 or
greater than $52. This type of trading strategy is known as a strangle.

24. What is a lower bound for the price of a six-month call option on a non-dividend-paying
stock when the stock price is $80, the strike price is $75, and the risk-free interest rate is
10% per annum?
Answer:
The lower bound is 80 − 75e−0105 = $866

25. What is a lower bound for the price of a two-month European put option on a non-dividend-
paying stock when the stock price is $58, the strike price is $65, and the risk-free interest
rate is 5% per annum?
Answer: The lower bound is

65e−005212 − 58 = $646

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 26. A four-month European call option on a dividend-paying stock is currently selling for $5.
The stock price is $64, the strike price is $60, and a dividend of $0.80 is expected in one
month. The risk-free interest rate is 12% per annum for all maturities. What opportunities
are there for an arbitrageur?
Answer: The present value of the strike price is 60e−0.124 /12 = $57.65 . The present value of the
dividend is 080e−012112 = 079 . Because
5  64 − 5765 − 079
the condition in equation (10.8) is violated.
• An arbitrageur should buy the option and short the stock. This generates 64 – 5 = $59.
The arbitrageur invests $0.79 of this at 12% for one month to pay the dividend of $0.80
in one month.
• The remaining $58.21 is invested for four months at 12%. Regardless of what happens a
profit will materialize.
• If the stock price declines below $60 in four months, the arbitrageur loses the $5 spent on
the option but gains on the short position.
• The arbitrageur shorts when the stock price is $64, has to pay dividends with a present
value of $0.79, and closes out the short position when the stock price is $60 or less.
• Because $57.65 is the present value of $60, the short position generates at least 64 –
57.65 – 0.79 = $5.56 in present value terms. The present value of the arbitrageur’s gain is
therefore at least 5.56 – 5.00 = $0.56.
• If the stock price is above $60 at the expiration of the option, the option is exercised. The
arbitrageur buys the stock for $60 in four months and closes out the short position.
• The present value of the $60 paid for the stock is $57.65 and as before the dividend has a
present value of $0.79. The gain from the short position and the exercise of the option is
therefore exactly 64 – 57.65 − 0.79 = $5.56.
• The arbitrageur’s gain in present value terms is 5.56 – 5.00 = $0.56.

27. A one-month European put option on a non-dividend-paying stock is currently selling

for $2.50. The stock price is $47, the strike price is $50, and the risk-free interest rate is
6% per annum. What opportunities are there for an arbitrageur?
Answer:

In this case the present value of the strike price is 50e−006112 = 4975 . Because
25  4975 − 4700
the condition is violated.

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 • An arbitrageur should borrow $49.50 at 6% for one month, buy the stock, and buy the put
option. This generates a profit in all circumstances.
• If the stock price is above $50 in one month, the option expires worthless, but the stock
can be sold for at least $50. A sum of $50 received in one month has a present value of
$49.75 today.
• The strategy therefore generates profit with a present value of at least $0.25.
• If the stock price is below $50 in one month the put option is exercised and the stock
owned is sold for exactly $50 (or $49.75 in present value terms).
• The trading strategy therefore generates a profit of exactly $0.25 in present value terms.

28. The price of a European call that expires in six months and has a strike price of $30 is $2.
The underlying stock price is $29, and a dividend of $0.50 is expected in two months and
again in five months. Risk-free interest rates for all maturities are 10%. What is the price
of a European put option that expires in six months and has a strike price of $30?
Answer: Using the notation in the book, put-call parity equation gives

c + Ke − rT + D = p + S0
or

p = c + Ke − rT + D − S 0
In this case

p = 2 + 30e−01612 + (05e−01212 + 05e−01512 ) − 29 = 251

In other words, the put price is $2.51

29. The price of an American call on a non-dividend-paying stock is $4. The stock price is $31,
the strike price is $30, and the expiration date is in three months. The risk-free interest rate
is 8%. Derive upper and lower bounds for the price of an American put on the same stock
with the same strike price and expiration date.
Answer:
S0 − K  C − P  S0 − Ke − rT
In this case

31 − 30  4 − P  31 − 30e−008025
or
100  400 − P  159
or
241  P  300
Upper and lower bounds for the price of an American put are therefore $2.41 and $3.00.

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 30. The prices of European call and put options on a non-dividend-paying stock with 12
months to maturity, a strike price of $120, and an expiration date in 12 months are $20 and
$5, respectively. The current stock price is $130. What is the implied risk-free rate?
Answer: From put-call parity
20+120e−r×1=5+130
Solving this
e−r = 115/120
so that r = −ln (115/120)=0.0426 or 4.26%
31. Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $7,
respectively. How can the options be used to create (a) a bull spread and (b) a bear
spread? Construct a table that shows the profit and payoff for both spreads.
Answer: A bull spread is created by buying the $30 put and selling the $35 put. This strategy
gives rise to an initial cash inflow of $3. The outcome is as follows:

Stock Price Payoff Profit

ST  35 0 3

30  ST  35 ST − 35 ST − 32

ST  30 −5 −2

A bear spread is created by selling the $30 put and buying the $35 put. This strategy costs $3
initially. The outcome is as follows

Stock Price Payoff Profit

ST  35 0 −3

30  ST  35 35 − ST 32 − ST

ST  30 5 2

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 32. A call with a strike price of $60 costs $6. A put with the same strike price and expiration
date costs $4. Construct a table that shows the profit from a straddle. For what range of
stock prices would the straddle lead to a loss?
Answer: A straddle is created by buying both the call and the put. This strategy costs $10. The
profit/loss is shown in the following table:
Stock Price Payoff Profit

ST  60 ST − 60 ST − 70

ST  60 60 − ST 50 − ST

This shows that the straddle will lead to a loss if the final stock price is between $50 and $70.

33. Three put options on a stock have the same expiration date and strike prices of $55, $60,
and $65. The market prices are $3, $5, and $8, respectively. Explain how a butterfly spread
can be created. Construct a table showing the profit from the strategy. For what range of
stock prices would the butterfly spread lead to a loss?

Answer: A butterfly spread is created by buying the $55 put, buying the $65 put and selling two
of the $60 puts. This cost 3 + 8 − 2  5 = $1 initially. The following table shows the profit/loss
from the strategy.
Payoff Profit
Stock Price

ST  65 0 −1

60  ST  65 65 − ST 64 − ST

55  ST  60 ST − 55 ST − 56

ST  55 0 −1

The butterfly spread leads to a loss when the final stock price is greater than $64 or less than $56.

34. Suppose that the price of a non-dividend-paying stock is $32, its volatility is 30%, and the
risk-free rate for all maturities is 5% per annum. Use DerivaGem to calculate the cost of
setting up the following positions. In each case provide a table showing the relationship
between profit and final stock price. Ignore the impact of discounting.
a. A bull spread using European call options with strike prices of $25 and $30 and a
maturity of six months.
b. A bear spread using European put options with strike prices of $25 and $30 and a
maturity of six months

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 c. A butterfly spread using European call options with strike prices of $25, $30, and
$35 and a maturity of one year.
d. A butterfly spread using European put options with strike prices of $25, $30, and
$35 and a maturity of one year.
e. A straddle using options with a strike price of $30 and a six-month maturity.
f. A strangle using options with strike prices of $25 and $35 and a six-month maturity.

Answer: (a) A call option with a strike price of 25 costs 7.90 and a call option with a strike price
of 30 costs 4.18. The cost of the bull spread is therefore 790 − 418 = 372 . The profits ignoring
the impact of discounting are

Stock Price Range Profit

ST  25 −372

25  ST  30 ST − 2872

ST  30 1.28

(b) A put option with a strike price of 25 costs 0.28 and a put option with a strike price of 30
costs 1.44. The cost of the bear spread is therefore 144 − 028 = 116 . The profits ignoring the
impact of discounting are
Stock Price Range Profit

ST  25 +384

25  ST  30 2884 − ST

ST  30 −116

(c) Call options with maturities of one year and strike prices of 25, 30, and 35 cost 8.92, 5.60,
and 3.28, respectively. The cost of the butterfly spread is therefore 892 + 328 − 2  560 = 100 .
The profits ignoring the impact of discounting are
Stock Price Range Profit

ST  25 −100

25  ST  30 ST − 2600

30  ST  35 3400 − ST

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 (d) Put options with maturities of one year and strike prices of 25, 30, and 35 cost 0.70, 2.14,
4.57, respectively. The cost of the butterfly spread is therefore 070 + 457 − 2  214 = 099 .
Allowing for rounding errors, this is the same as in (c). The profits are the same as in (c).

(e) A call option with a strike price of 30 costs 4.18. A put option with a strike price of 30 costs
1.44. The cost of the straddle is therefore 418 + 144 = 562 . The profits ignoring the impact of
discounting are
Stock Price Range Profit

ST  30 24.38 − ST

ST  30 ST − 3562

(f) A six-month call option with a strike price of 35 costs 1.85. A six-month put option with a
strike price of 25 costs 0.28. The cost of the strangle is therefore 185 + 028 = 213 . The profits
ignoring the impact of discounting are
Stock Price Range Profit

ST  25 2287 − ST

25  ST  35 −2.13

ST  35 ST − 3713

35. A stock price is currently $80. It is known that at the end of four months it will be either
$75 or $85. The risk-free interest rate is 5% per annum with continuous compounding.
What is the value of a four-month European put option with a strike price of $80? Use no-
arbitrage arguments.
Answer:
At the end of four months the value of the option will be either $5 (if the stock price is $75) or $0
(if the stock price is $85). Consider a portfolio consisting of:
−  shares
+1  option
(Note: The delta,  of a put option is negative. We have constructed the portfolio so that it is +1
option and − shares rather than −1 option and + shares so that the initial investment is
positive.)
The value of the portfolio is either −85 or −75 + 5 in four months. If

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 −85 = −75 + 5
i.e.,
 = −05
the value of the portfolio is certain to be 42.5. For this value of  the portfolio is therefore
riskless. The current value of the portfolio is:
05  80 + f
where f is the value of the option. Since the portfolio is riskless

(05  80 + f )e005412 = 425

i.e.,
f = 180
The value of the option is therefore $1.80.
This can also be calculated directly from equations (12.2) and (12.3). u = 10625 , d = 09375 so
that

e0054 12 − 09375

p= = 06345
10625 − 09375
1 − p = 03655 and

f = e−005412  03655  5 = 180

36. A stock price is currently $40. It is known that at the end of three months it will be either
$45 or $35. The risk-free rate of interest with quarterly compounding is 8% per annum.
Calculate the value of a three-month European put option on the stock with an exercise
price of $40. Verify that no-arbitrage arguments and risk-neutral valuation arguments
give the same answers.
Answer:
At the end of three months the value of the option is either $5 (if the stock price is $35) or $0 (if
the stock price is $45).
Consider a portfolio consisting of:
−  shares
+1  option
(Note: The delta,  , of a put option is negative. We have constructed the portfolio so that it is +1
option and − shares rather than −1 option and + shares so that the initial investment is
positive.)
The value of the portfolio is either −35 + 5 or −45 . If:
−35 + 5 = −45
i.e.,
 = −05
the value of the portfolio is certain to be 22.5. For this value of  the portfolio is therefore
riskless. The current value of the portfolio is

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 −40 + f
where f is the value of the option. Since the portfolio must earn the risk-free rate of interest
(40  05 + f ) 102 = 225
Hence
f = 206
i.e., the value of the option is $2.06.
This can also be calculated using risk-neutral valuation. Suppose that p is the probability of an
upward stock price movement in a risk-neutral world. We must have
45 p + 35(1 − p) = 40 102
i.e.,
10 p = 58
or:
p = 058
The expected value of the option in a risk-neutral world is:
0  058 + 5  042 = 210
This has a present value of
210
= 206
102
This is consistent with the no-arbitrage answer.

37. A stock price is currently $50. Over each of the next two three-month periods it is
expected to go up by 6% or down by 5%. The risk-free interest rate is 5% per annum with
continuous compounding. What is the value of a six-month European call option with a
strike price of $51?
Answer:
A tree describing the behavior of the stock price is shown in the plot shown below. The risk-
neutral probability of an up move, p, is given by

e005312 − 095
p= = 05689
106 − 095
There is a payoff from the option of 5618 − 51 = 518 for the highest final node (which
corresponds to two up moves) zero in all other cases. The value of the option is therefore

518  056892  e−005612 = 1635

This can also be calculated by working back through the tree as indicated in the plot. The value
of the call option is the lower number at each node in the figure.

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 38. Calculate u , d , and p when a binomial tree is constructed to value an option on a
foreign currency. The tree step size is one month, the domestic interest rate is 5% per
annum, the foreign interest rate is 8% per annum, and the volatility is 12% per annum.
Answer:
In this case

a = e(005−008)112 = 09975

u = e012 112
= 10352

d = 1  u = 09660

09975 − 09660
p= = 04553
10352 − 09660

39. The volatility of a non-dividend-paying stock whose price is $78, is 30%. The risk-free rate is 3%
per annum (continuously compounded) for all maturities. Calculate values for u, d, and p when a
two-month time step is used. What is the value of a four-month European call option with a strike
price of $80 given by a two-step binomial tree. Suppose a trader sells 1,000 options (10 contracts).
What position in the stock is necessary to hedge the trader’s position at the time of the trade?
Answer:
u = e 0.30 0.1667 = 1.1303
d = 1 / u = 0.8847
e 0.302 / 12 − 0.8847
p= = 0.4898
1.1303 − 0.8847

The tree is given below. The value of the option is $4.67. The initial delta is 9.58/ (88.16 –
69.01) which is almost exactly 0.5 so that 500 shares should be purchased.

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 99.65
19.65
88.16
9.58
78.00 78.00
4.67 0.00
69.01
0.00
61.05
0.00

40. A stock price is currently $40. Over each of the next two three-month periods it is
expected to go up by 10% or down by 10%. The risk-free interest rate is 12% per annum
with continuous compounding.
What is the value of a six-month European put option with a strike price of $42?
What is the value of a six-month American put option with a strike price of $42?
Answer:
a. A tree describing the behavior of the stock price is shown in the binomial tree. The risk-
neutral probability of an up move, p , is given by
e012312 − 090
p= = 06523
1  1 − 0 9
Calculating the expected payoff and discounting, we obtain the value of the option as

[24  2  06523  03477 + 96  03477 2 ]e−012612 = 2118

The value of the European option is 2.118. This can also be calculated by working back
through the tree as shown in Binomial tree. The second number at each node is the value
of the European option.
b. The value of the American option is shown as the third number at each node on the tree.
It is 2.537. This is greater than the value of the European option because it is optimal to
exercise early at node C.

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 44.000
48.400
0.810
0.000
0.810
0.000
B
40.000 39.600
2.118 A
2.400
2.537 C 2.400
36.000 32.400
4.759 9.600
6.000 9.600

41. What is the price of a European call option on a non-dividend-paying stock when the
stock price is $52, the strike price is $50, the risk-free interest rate is 12% per annum, the
volatility is 30% per annum, and the time to maturity is three months?
Answer:
In this case, S0 = 52 , K = 50 , r = 012 ,  = 030 , and T = 025 .

ln(52  50) + (012 + 032  2)025

d1 = = 05365
030 025
d 2 = d1 − 030 025 = 03865
The price of the European call is

52 N (05365) − 50e−012025 N (03865)

= 52  07042 − 50e−003  06504

= 506
or $5.06.

42. What is the price of a European put option on a non-dividend-paying stock when the
stock price is $69, the strike price is $70, the risk-free interest rate is 5% per annum, the
volatility is 35% per annum, and the time to maturity is six months?

In this case, S0 = 69 , K = 70 , r = 005 ,  = 035 , and T = 05 .

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 ln(69  70) + (005 + 0352  2)  05
d1 = = 01666
035 05
d 2 = d1 − 035 05 = −00809
The price of the European put is

70e−00505 N (00809) − 69 N (−01666)

= 70e−0025  05323 − 69  04338

= 640
or $6.40.

43. Consider an option on a non-dividend-paying stock when the stock price is $30, the
exercise price is $29, the risk-free interest rate is 5% per annum, the volatility is 25% per
annum, and the time to maturity is four months.
a. What is the price of the option if it is a European call?
b. What is the price of the option if it is an American call?
c. What is the price of the option if it is a European put?
d. Verify that put–call parity holds.

Answer:

In this case S0 = 30 , K = 29 , r = 005 ,  = 025 and T = 4  12

ln(30  29) + (005 + 0252  2)  4  12
d1 = = 04225
025 03333

ln(30  29) + (005 − 0252  2)  4  12

d2 = = 02782
025 03333

N (04225) = 06637 N (02782) = 06096

N (−04225) = 03363 N (−02782) = 03904

a. The European call price is

30  06637 − 29e−005412  06096 = 252
or $2.52.

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b. The American call price is the same as the European call price. It is $2.52.
c. The European put price is
29e−005412  03904 − 30  03363 = 105
or $1.05.
d. Put-call parity states that:
p + S = c + Ke− rT
In this case c = 252 , S0 = 30 , K = 29 , p = 105 and e−rT = 09835 . it is easy to verify that the
relationship is satisfied,

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