Relative Resource Manager

Second Semester, 2011-2012
THE UNIVERSITY OF HONG KONG

DEPARTMENT OF STATISTICS AND ACTUARIAL SCIENCE
STAT2807 CORPORATE FINANCE FOR ACTUARIAL SCIENCE
Tutorial 10 (Finale): Option Prices Date: April 23 24, 2012
What is This Final Tutorial About?
In this nal tutorial, we will study the fundamentals of option pricing theory. After
exploring the properties of option prices that the no-arbitrage assumption necessitates, we
will briey introduce the binomial option pricing model, the method of replicating portfolio
and risk-neutral valuation. The problem section includes a large number of instructive
exercises, which are collected from a wealth of sources to strengthen your understanding.
1 Key Learning Points
In the examination, candidates are expected to:
LP(1) State, prove and manipulate the put-call parity.
LP(2) Use no-arbitrage arguments to prove inequalities involving option prices.
LP(3) Detect the existence of arbitrage opportunities, and if they exist, construct a portfolio to
reap risk-free prot.
LP(4) Calculate the value of an option with a possibly unfamiliar payo structure by (i) the
method of replicating portfolio, and (ii) risk-neutral valuation.
#
"
!
Message from Ambrose
This is the last tutorial. Enjoy!
2 Review of Key Concepts
2.1 Identities and Inequalities of Option Prices
The no-arbitrage assumption eectively makes option prices non-arbitrary. As functions
of the stock price, strike price, time to maturity, they have to satisfy a number of identities
and inequalities, including:
S&AS: STAT2807 Corporate Finance for Actuarial Science Ambrose LO 2012 2
1. (IMPORTANT!) Put-call parity: C
E
0
+ Ke
rT
= S
0
+ P
E
0
.
2. Call prices are bounded (above and below): S
t
Ke
r(Tt)
C
A/E
t
S
t
.
3. Put prices are bounded: Ke
r(Tt)
S
t
P
A/E
t
Ke
r(Tt)
.
4. Call prices are decreasing functions of the strike price: C
t
(K
1
) C
t
(K
2
) if K
1
K
2
.
Interpretation: This is natural as the higher the strike price K, the lower the
payo of a call option (S
T
K)
+
.
5. Put prices are increasing functions of the strike price: P
t
(K
1
) P
t
(K
2
) if K
1
K
2
.
Interpretation: The payo of a put option is (K S
T
)
+
, which increases with K.
6. Option prices are increasing in the time-to-maturity: If T
1
> T
2
,
C
t
(T
1
) C
t
(T
2
) and P
t
(T
1
) P
t
(T
2
).
7. Option prices are convex
1
in the strike price (Problem 2 (a), Section 3.3): For all
[0, 1],
C
t
[K
1
+ (1 )K
2
] C
t
(K
1
) + (1 )C
t
(K
2
)
P
t
[K
1
+ (1 )K
2
] P
t
(K
1
) + (1 )P
t
(K
2
)
8. Option prices are Lipschitz
2
in the strike price (Assignment 3):
|C
1t
C
2t
| e
r(Tt)
|K
1
K
2
|,
|P
1t
P
2t
| e
r(Tt)
|K
1
K
2
|.
What will I be asked in the Final Exam?
In the Final Exam, you may be asked to:
Apply put-call parity to perform some calculations, or
Prove any of the above inequalities.
Another possibility is to present some observed option prices and ask you whether the
market is arbitrage-free. Almost surely (otherwise, what is the point of that exam ques-
tion!?!?) there will be arbitrage opportunities and you can follow the steps on page 4 to
construct an arbitrage strategy.
1
Recall that a real-valued function f dened on a convex set X is said to be convex if f(x
1
+(1 )x
2
)
f(x
1
) + (1 )f(x
2
) for all x
1
, x
2
X and [0, 1].
2
A real-valued function f dened on a set X is said to be Lipschitz if there exists L > 0 such that |f(x)
f(y)| L|x y| for all x, y X.
Exercise 1. (SOA Exam MFE Sample Q1: Straightforward Put-call Parity Manipu-
lations) Consider a European call option and a European put option on a nondividend-paying
stock. You are given:
The current price of the stock is 60.
The call option currently sells for 0.15 more than the put option.
Both the call option and put option will expire in 4 years.
Both the call option and put option have a strike price of 70.
Calculate the continuously compounded risk-free interest rate.
Solution. Applying put-call parity, we have
C
0
P
0
= S
0
Ke
rT
0.15 = 60 70e
4r
r = 0.039 .
Exercise 2. (SOA Exam MFE Spring 2009) You are given:
C(K, T) denotes the current price of a K-strike T-year European call option on a
nondividend-paying stock.
P(K, T) denotes the current price of a K-strike T-year European call option on a
nondividend-paying stock.
S denotes the current price of the stock.
The continuously compounded risk-free interest rate is r.
Which of the following is (are) correct?
(I) 0 C(50, T) C(55, T) 5e
rT
(II) 50e
rT
P(45, T) C(50, T) + S 55e
rT
(III) 45e
rT
P(45, T) C(50, T) + S 50e
rT
Solution. (I) is true. Call price is a decreasing function of K, so C(50, T) C(55, T).
The second inequality follows from Assignment 3 (Lipschizity).
(II) is incorrect, but (III) is true. By put-call parity,
P(45, T) C(50, T) + S = [C(45, T) S + 45e
rT
] C(50, T) + S
= C(45, T) C(50, T) + 45e
rT
.
By (I), 0 C(45, T) C(50, T) (50 45)e
rT
, which is equivalent to
45e
rT
C(45, T) C(50, T) + 45e
rT
50e
rT
.
(IMPORTANT!) How to Prove These Identities/Inequalities Systematically?
Suppose you want to prove
(<)
. (1)
Step 1. Assume the contrary to (1), i.e.
()
> .
Step 2. Buy low and sell high.
At time 0, enter the transactions with a cost of . For example, if =
C
t
(S
t
, K, T), then you should buy a call option.
At the same time, short the transactions which cost . For example, if =
S
t
K exp
r(Tt)
, then you should short sell an asset and lend K exp
r(Tt)
.
Step 3. Verify that arbitrage prots exist by showing that the cashow at time 0 is
positive (non-negative), and the cashow at the maturity date T is non-negative.
For clarity, you can present your answers in a table:
Transaction 1 Transaction 2 Total
S
T
< K ( 0?)
S
T
K ( 0?)
Step 4. Argue that you have constructed an arbitrage strategy, so (1) must hold.
There are no better exercises than verifying as many of the identities and inequalities
above on your own. Check your proof with the one in the notes. To test your under-
standing, some additional inequalities are provided in Problems 1 and 2 in Section 3.3.
2.2 Binomial Option Pricing Model (OPTIONAL)
2.2.1 Basics
Using binomial trees is a general, robust, but computationally intensive method to price op-
tions
3
. Although simple expressions of option prices may not be available, all options can be
priced theoretically.
Construction of Binomial Trees: Under the binomial option pricing model, the stock
price in the next time period is assumed to move either up by a factor of u or down by a
factor of d:
S
0
S
u
= S
0
u
S
d
= S
0
d
3
Black-Scholes pricing formulae will not be treated in this course.
(Note: S is not always the underlying risky stock. It only has to be an asset from which
the value of a derivative can be derived directly. For a compound option (May 2009 Exam
Question 10), S is actually the price of another option!)
In this course, we shall not pursue issues concerning the determination of u and d. In
other words, the values of u and d are assumed to be given.
Objective: The time-0 price of a derivative with payos f
u
and f
d
in the next period.
Note that this derivative need not be a standard call or put option. Any payo structures
(e.g. May 2010 Exam Question 9 and Problem 1, Section 3.4), regardless of its irregularity,
can be tackled by the binomial tree method.
Case 1. One-period Binomial Tree
Method 1: Replicating Portfolio (Good for one-period model)
This method involves solving a pair of simultaneous equations. Construct a port-
folio consisting of shares of stock and cash of , to mimick the payo of the
derivative of interest:
_
S
0
u + e
rT
= f
u
S
0
d + e
rT
= f
d
= =? , =? .
(Note: You need not remember the expressions of and .) By the law of one price,
the option price must be equal to the initial cost in constructing the replicating
portfolio, which is
S
0
+ .
Method 2: Risk-neutral Valuation (Good for most cases!)
Dene the risk-neutral probability
q
e
rT
d
u d
.
Then the option price can be rewritten as
e
rT
[qf
u
+ (1 q)f
d
] = e
rT
E
Q
[Payo].
Interpretation The price of an option can be evaluated as a discounted expected
payo, where:
1. discounted means discounting by the risk-free rate, and
2. expected means the expectation when the stock moves up with a proba-
bility of q (but not the true probability!).
Case 2. Multi-period Binomial Tree
It is much easier to employ risk-neutral valuation (Method 2) when we have several
periods in the binomial tree. By working backward through the binomial tree and con-
sidering each node as a single-period binomial tree model, the option can be recursively
valued.
Important Special Case: For European options, early exercise is not allowed.
Therefore, we can simply discount the expected payo at the end of the binomial
tree back to time 0.
1. For a two-period tree, the price of the derivative is
e
rT
[q
2
f
uu
+ 2q(1 q)f
ud
+ (1 q)
2
f
dd
].
2. For a three-period tree, the price becomes
e
rT
[q
3
f
uuu
+ 3q
2
(1 q)f
uud
+ 3q(1 q)
2
f
udd
+ (1 q)
3
f
ddd
].
Case 3. Trinomial Tree (This part is more challenging; suitable for more motivated students)
The risk-neutral probabilities for a stock to go up, stay put and go down are more dicult
to obtain for a multinomial tree. In this case, the method of replicating portfolio comes
to our rescue. The same idea, i.e. constructing a portfolio with available assets such that
the payo of the derivative can be replicated, still works, but a larger system of linear
equations has to be solved. Please try Problem 3 in Section 3.4 for such a nonstandard
problem.
2.2.2 American Options
Idea: For American options, the same kind of recursive risk-neutral valuation for Eu-
ropean options can be performed. The option price at each node of the tree is given
by
max {discounted expected payo, payo from early exercise} .
Important Special Case: If the underlying stock pays no dividends (as is the case in
our course), then an American call is worth the same as a European call. Early exercise
need not be accounted for.
Exercise 3. (SOA Exam MFE Sample Question 4: A Standard Exercise) For a
two-period binomial model, you are given:
Each period is one year.
The current price for a nondividend-paying stock is 20.
u = 1.2840.
d = 0.8607.
The continuously compounded risk-free interest rate is 5%.
Calculate the price of an American call option on the stock with a strike price of 22.
Solution. The two-period binomial tree is constructed in Figure 1. The risk-neutral proba-
bility for the stock price to go up is
q =
e
0.05
0.8607
1.2840 0.8607
= 0.450203.
At node B: The value of the call option is
max
_
_
_
e
0.05
[q(10.9731) + (1 q)(0.1028)]
. .
=4.752922
, (25.680 22)
+
. .
=3.680
_
_
_
= 4.752922.
At node C: The value of the call option becomes
max
_
_
_
e
0.05
[q(0.1028) + (1 q)(0)]
. .
=0.044023
, (17.214 22)
+
. .
=0
_
_
_
= 0.044023.
Early exercise is not optimal.
At node A: Finally, the call price is
max
_
_
_
e
0.05
[q(4.752922) + (1 q)(0.044023)]
. .
=2.0584
, (20 22)
+
. .
=0
_
_
_
= 2.0584 .
Remark 1. As the stock pays no dividends, the American call price must be equal to the
European call price.
20
A
25.68
B
17.214
C
32.9731 (10.9731)
22.1028 (0.1028)
14.8161 (0)
Figure 1: Binomial tree for Exercise 3.
3 Problems
Attempt ALL NINE questions in Sections 3.1 to 3.4. Marks for past paper ques-
tions are shown in square brackets.
'
&
$
%
Message from Ambrose
This problem section contains a wide variety of nonstandard questions
collected from past tests and examinations of a number of courses. In spite
of the sheer number of questions, please try as many of them as possible
during your revision!
3.1 Miscellaneous Descriptive Questions
1. Miscellaneous Short Questions
(a) Explain how an option holder gains from the volatility of the underlying stock price. STAT2807
07-08
Exam
[4 marks]
Solution. An option holder gains from the volatility of the underlying stock price be-
cause of the asymmetric payos of options.
For example, if the stock price falls below the exercise price, a call option will be
worthless, regardless of whether the drop in the price is only a few cents or many
dollars.
On the other hand, for every dollar stock price increase above the exercise price,
the call option payo will increase by the same amount. Hence, the option holder
gains from the increased volatility on the upside, but does not lose on the down
side.
(b) Explain put-call parity in words.
Solution. The relationship between the value of a European option and the value
of an equivalent put option is called put-call parity.
It holds only if the investor is committed to holding the options until the exercise
date. It does not hold for American options.
3.2 Put-Call Parity
1. A Simple Warm-up Question
You are given the following option prices for European puts and calls with the same time to STAT2812
11-12
Exam
expiration:
Strike Price Put Call
98 0.4394 14.3782
100 0.6975 12.7575
Calculate the current price of the stock.
Solution. Applying put-call parity to the strike prices 98 and 100 respectively yields
_
14.3782 0.4394 = S
0
98e
rT
12.7575 0.6975 = S
0
100e
rT
.
It follows that e
rT
= 0.9394 and S
0
= 106 .
2. (Challenging!) Further Encounters with Put-Call Parity
You are given the following four European options, all written on the same underlying non- STAT2820
10-11
Exam
dividend paying stock and with the same maturity date which is one year later.
Call/Put Strike Price Price
Call 25 6.85
Call 35 1.77
Put 25 0.63
Put 35 5.06
Suppose the risk-free rate is 6% per annum compounded continuously. Construct a strategy
to earn risk-free prots at time 0 using the above options and/or zero-coupon bonds only.
[Total: 10 marks]
Solution. On rst encounter, this question may seem intimidating.
Analysis We are given two pairs of call-put prices with dierent strike prices. For each
pair, we can make use of put-call parity to deduce the fair time-0 stock price.
To create an arbitrage strategy, long the pair with a lower stock price and short
the one which gives a higher stock price, i.e. buy low and sell high.
Action! Applying put-call parity to the 25-strike pair gives
6.85 0.63 = S
0
25e
0.06
S
25-strike
0
= 29.7641. Higher!
Applying put-call parity to the 35-strike pair yields
1.77 5.06 = S
0
35e
0.06
S
35-strike
0
= 29.6718. Lower!
Construction of Strategy
At time 0, we long a 35-strike call, a 25-strike put, short a 35-strike put, a
25-strike call and lend (35 20)e
0.06
= 10e
0.06
. The cashow is
(1.77 + 0.63) + (5.06 + 6.85) 10e
0.06
= 0.0923 > 0.
At time 1, the cashow is as follows:
L35C L25P S35P S25C loan proceeds Total
S
1
< 25 0 25 S
1
(35 S
1
) 0 10 0
25 S
1
< 35 0 0 (35 S
1
) (S
1
25) 10 0
S
1
> 35 S
1
35 0 0 (S
1
25) 10 0
The cashow at time 1 is always zero, no matter what the stock price is. An
arbitrage strategy is thus constructed.
3. Put-call Parity for Gap Options
A gap call option is a European call option whose payo at maturity time T is given by
payo =
_
S
T
K
1
, if S
T
> K
2
,
0, if S
T
K
2
,
where S
T
is the price of the underlying non-dividend paying stock, K
1
and K
2
are positive
constants, called the strike price and trigger price respectively. Similarly, the payo of a
European gap put option with strike price K
1
and trigger price K
2
is given by
payo =
_
K
1
S
T
, if S
T
< K
2
,
0, if S
T
K
2
.
(a) Sketch the payos of the above gap call option when (i) K
1
< K
2
; (ii) K
1
K
2
.
(b) State the functions of the strike price K
1
and the trigger price K
2
in determining the
payo of a gap option.
(c) Let C
gap
t
and P
gap
t
denote the time-t prices of a European gap call and gap put option
respectively, both with strike price K
1
and trigger price K
2
. For t T, prove, by
no-arbitrage arguments that,
C
gap
t
P
gap
t
= S
t
K
1
e
r(Tt)
.
Solution. (a) The payo diagrams are shown below.
Payo
S
T
K
1
K
2
Payo
S
T
K
2
K
1
Figure 2: Left: K
1
< K
2
; right: K
1
K
2
(b) Strike price K
1
: Used to determine the size of the payo
Trigger price K
2
: Used to determine whether a payo should be paid
(c) (Modied from page 1 of lecture notes) Construct:
Portfolio 1: Long 1 gap call option and short 1 gap put option, both with strike
price K
1
and trigger price K
2
. The total cashow at maturity is:
long call short put Total
S
T
< K
2
0 (K
1
S
T
) S
T
K
1
S
T
K
2
S
T
K
1
0 S
T
K
1
Portfolio 2: Hold one unit of the underlying stock and borrow $K
1
e
r(Tt)
cash. The
total cashow at maturity is:
long asset cash Total
S
T
< K
2
S
T
K
1
S
T
K
1
S
T
K
2
S
T
K
1
S
T
K
1
Observe that the cashows of the two portfolios are the same, no matter S
T
K
2
or
S
T
< K
2
. By the no-arbitrage principle, the cost of constructing these two portfolios
must be the same, i.e. C
gap
t
P
gap
t
= S
t
K
1
e
r(Tt)
.
3.3 Option Inequalities
1. Lower bound for Call Price with Dividends STAT2820
09-10
Test
Let C
0
(K, T) be the time-0 price of a European call option on a stock, with strike price K
and expiry date T. Interest rate is r per annum, compounded continuously. Stock price at
time 0 is S
0
. The stock pays discrete dividends in the time interval (0, T). Let D be the
present value (time-0 value) of all these dividends. Prove, by no-arbitrage arguments, that
C
0
(K, T) S
0
Ke
rT
D.
[Total: 10 marks]
Proof. Assume, on the contrary, that C
0
(K, T) < S
0
Ke
rT
D. At t = 0, we buy the
call option, short sell the stock and lend Ke
rT
+D. The resulting cashow is S
0
Ke
rT
D C
0
(K, T) > 0.
At time T, the cashow is as follows:
Long call Repay short sale of asset + dividends Proceeds from loan Total
S
T
< K 0 S
T
De
rT
K +De
rT
K S
T
> 0
S
T
K S
T
K S
T
De
rT
K +De
rT
0
The cashow at time T is always nonnegative, indicating that arbitrage exists. The stated
inequality is then proved.
2. Suppose the current time is 0. Consider two European put options on the same underlying STAT2820
11-12
Exam
(non-dividend paying) stock and the same maturity date T, but with dierent strike prices
K
1
and K
2
, where K
1
K
2
. The prices of the above options are denoted by P(K
1
) and
P(K
2
) respectively. Use no-arbitrage arguments to show that
K
2
P(K
1
) K
1
P(K
2
).
[Total: 7 marks]
Proof. Suppose, on the contrary, that K
2
P(K
1
) > K
1
P(K
2
).
At time 0, we buy K
1
put options with a strike price of K
2
and sell K
2
put options
with a strike price of K
1
, realizing a positive cashow of K
2
P(K
1
) K
1
P(K
2
) > 0.
At the maturity date T, the cashow is as follows:
Long K
1
K
2
-strike puts Short K
2
K
1
-strike puts Total
S
T
K
1
K
1
(K
2
S
T
) K
2
(K
1
S
T
) (K
2
K
1
)S
T
0
K
1
< S
T
K
2
K
1
(K
2
S
T
) 0 K
1
(K
2
S
T
) 0
K
2
< S
T
0 0 0
As the payo at time T is always non-negative, arbitrage prots exist. Thus we have
K
2
P(K
1
) K
1
P(K
2
).
3. Convexity of Option Prices
(a) Suppose that c
1
, c
2
and c
3
are the prices of European call options written on the same STAT2807
10-11
08-09
05-06
Exam
(Ex-
tended)
underlying stock. Their strike prices are K
1
, K
2
and K
3
respectively, where K
2
> K
3
>
K
1
, and they satisfy
(n
1
+ n
2
)K
3
= n
1
K
1
+ n
2
K
2
, n
1
and n
2
are some positive integers.
All options have the same maturity.
(i) Show that
c
3
<
n
1
n
1
+ n
2
c
1
+
n
2
n
1
+ n
2
c
2
.
[8 marks]
(ii) New! Explain in words the meaning of the result in (i).
(iii) New! Hence or otherwise, prove the corresponding inequality for put options.
(b) Near market closing time on a given day, you lose access to stock prices, but some STAT2812
10-11
Exam
SOA
MFE
Sample
Q2
European call and put prices for a stock are available as follows:
Strike Price Call Price Put Price
$40 $11 $3
$50 $6 $8
$55 $3 $11
All six options have the same expiration date.
Construct two strategies based on dierent properties of option prices to exploit
arbitrage prots.
Solution. (a) (i) The stated inequality is equivalent to
(n
1
+ n
2
)c
3
< n
1
c
1
+ n
2
c
2
.
Assume the contrary, i.e. (n
1
+n
2
)c
3
n
1
c
1
+n
2
c
2
. Consider a portfolio in which n
1
K
1
-strike calls and n
2
K
2
-strike calls are purchased and (n
1
+n
2
) K
3
-strike calls are
sold. At time 0, we receive a non-negative cashow of (n
1
+n
2
)c
3
n
1
c
1
n
2
c
2
0.
At the maturity time T, the cashow is as follows:
Long K
1
-strike Long K
2
-strike Short K
3
-strike Total
call call call
S
T
< K
1
0 0 0 0
K
1
S
T
< K
3
n
1
(S
T
K
1
) 0 0 n
1
(S
T
K
1
)
K
3
S
T
< K
2
n
1
(S
T
K
1
) 0 (n
1
+n
2
)(K
3
S
T
) n
2
(K
2
S
T
) > 0
K
2
S
T
n
1
(S
T
K
1
) n
2
(S
T
K
2
) (n
1
+n
2
)(K
3
S
T
) 0
The payo is non-negative and even positive when S
T
[K
3
, K
2
). Hence arbitrage
exists, and we have
c
3
<
n
1
n
1
+ n
2
c
1
+
n
2
n
1
+ n
2
c
2
.
(ii) The inequality in (a) implies that call price, as a function of the strike price K, is
convex.
(iii) By put-call parity, the inequality in (i) can be expressed in terms of put prices:
p
3
+ S
0
K
3
e
rT
<
n
1
n
1
+ n
2
(p
1
+ S
0
K
1
e
rT
) +
n
2
n
1
+ n
2
(p
2
+ S
0
K
2
e
r
T).
Since by assumption, (n
1
+n
2
)K
3
= n
1
K
1
+n
2
K
2
, all terms involving asset prices
and strike prices cancel and we nally get
p
3
<
n
1
n
1
+ n
2
p
1
+
n
2
n
1
+ n
2
p
2
.
(b) (i) First Property: Convexity
With n
1
= 1, n
2
= 2, K
1
= 40, K
3
= 50, K
2
= 55, the inequalities in (a)(i) and
(a)(iii) take the form
c
3
<
1
3
(11) +
2
3
(3) =
17
3
= 5.6667 and p
3
<
1
3
(3) +
2
3
(11) =
25
3
= 8.3333.
Since c
3
= 6, the rst inequality is violated
4
. To exploit arbitrage prots, we
construct the following portfolio:
At time 0, we sell three 50-strike calls and buy one 40-strike call and two
55-strike calls, resulting in a positive cashow of 6(3) 11 2(3) = 1.
At the expiration date, the cashow is always non-negative:
S50C L40C L55C Total
S
T
< 40 0 0 0 0
40 S
T
< 50 0 S
T
40 0 S
T
40 0
50 S
T
< 55 3(S
T
50) S
T
40 0 2S
T
+ 110 > 0
K
2
55 3(S
T
50) S
T
40 2(S
T
55) 0
4
The put prices, however, satisfy convexity.
(ii) Second Property: Put-Call Parity
Starting Point: Unlike Problem 2 in Section 3.2, here we are not even given
the continuously compounded interest rate r and the maturity time T. However,
put-call parity implies that we have
_
_
8 = S
0
40e
rT
2 = S
0
50e
rT
8 = S
0
55e
rT
,
which is an inconsistent linear system in the variables (S
0
, e
rT
). In fact, the
second and third equations imply that S
0
= 58 and e
rT
= 1.2, which, upon
substitution into the rst equation, give
S
0
40e
rT
= 58 40(1.2) = 10 > 8.
For the ease of presentation, we dene the following three options to be the posi-
tions obtained by longing a call and shorting a put, both with the same strike price
of 40, 50 and 55 respectively:
Strike Price Option Cost of Option
$40 1 11 3 = 8
$50 2 6 8 = 2
$55 3 3 11 = 8
Put-call parity asserts that the cost of Option 1 is also equal to S
0
40e
rT
. Note
that
S
0
40e
rT
= 3(S
0
50e
rT
) + (2)(S
0
55e
rT
).
[How to Get This? You can set up a(S
0
50e
rT
) +b(S
0
55e
rT
) = S
0
40e
rT
,
which gives
_
a + b = 1
50a 55b = 40
,
and solve for a and b.]
The cost of buying 3 units of Option 2 and selling 2 units of Option 3 is 2(3) +
(8)(2) = 10
..
high!
> 8
..
low!
. We are now ready to engage in the buy-low-sell-high
strategy!
At time 0, we buy 1 unit of Option 1, buy 2(= b) units of Option 3, sell 3 (or
buy a = 3) units of Option 2. The cashow is
8 2(8) + 3(2) = 2 > 0.
At the maturity time T, the cashow of Option i is S
T
K
i
, where i = 1, 2, 3
and K
1
= 40, K
2
= 50, K
3
= 55. Hence the overall cashow is given by
(S
T
40) + 2(S
T
55) 3(S
T
50) = 0.
We have thus constructed an arbitrage strategy.
Remark 2. In Problem 2, Section 3.2, we compared the implied values of S
0
, while
in this question, we compare the implied values of S
0
40e
rT
.
Remark 3. If you have conquered Problem 2 in Section 3.2 as well as this question,
...congratulations! Put-call parity is now nothing to you!
3.4 Two More Challenging Questions
1. Replicating an Unfamiliar Derivative STAT2820
10-11
Test
The payo of Derivative X maturing at the time T is given by
Payo =
_
_
5, if 0 S
T
< 10,
3S
T
25, if 10 S
T
< 20,
S
T
+ 15, if S
T
20,
where S
T
is the price of the underlying stock at time T.
(a) Sketch the payo of X against S
T
. [2 marks]
(b) Decompose the above payo into the payos of put option(s), the underlying stock,
and/or zero-coupon bond only. [5 marks]
(c) You are given:
The time to maturity of X is 1 year.
The risk-free interest rate is 5%.
At time 0, the stock price is 15.
The following put option prices are observed:
Strike Price Put Option Price
10 0.1
20 4.5
The time-0 price of X is 19.
Determine whether any arbitrage opportunity exists. If there is, construct a strategy
to earn risk-free prots; otherwise, explain your answer. [5 marks]
[Total: 12 marks]
Solution. (a) The payo of X against S
T
is sketched below:
Payo
S
T
5
10
35
20
(b) Note that the turning points of the payo function are at S
T
= 10 and S
T
= 20, which
must be the strike prices of the put options involved. Since put options are worthless
if S
T
20, the term S
T
+ 15 must come from the stock and bond.
Let payo = A(10 S
T
)
+
+B(20 S
T
)
+
+S
T
+15, where A and B are coecients to
be determined. Then
_
A(10 S
T
) + B(20 S
T
) + S
T
+ 15 = 5 if 0 S
T
10,
B(20 S
T
) + S
T
+ 15 = 3S
T
25 if 10 < S
T
20.
Solving yields A = 3 and B = 2. In conclusion, the payo can be decomposed as 3
(long) put options with strike 10, plus 2 short put options with strike 20, plus 1 stock
and bond with face value 15.
(c) The value of the replicating portfolio constructed in (b) is 3(0.1)2(4.5)+15+15e
0.05
=
20.5684, which is higher than the price of X. Thus an arbitrage opportunity exists.
At time 0, we short the replicating portfolio, i.e. short 3 10-strike put options,
long 2 20-strike put options, short 1 stock and borrow 15e
0.05
, and long X. The
cashow is 20.5684 19 = 1.5684 > 0.
At time T, the cashows are as follows:
long X short 3 10-strike put long 2 20-strike put short stock repay loan Total
0 S
T
< 10 5 3(10 S
T
) 2(20 S
T
) S
T
15 0
10 S
T
< 20 3S
T
25 0 2(20 S
T
) S
T
15 0
S
T
20 S
T
+ 15 0 0 S
T
15 0
The cashow at time T is always zero, irrespective of the stock price at the maturity
date. Hence this is an arbitrage.
2. Chooser Option STAT2820
11-12
Exam
Suppose the current time is 0. Consider a chooser option on a (non-dividend paying) stock.
At time t
1
(where t
1
0), the owner of the option can choose whether the option becomes
a European call option or a European put option, both with the same strike price K and
maturity date T (where T t
1
). The risk-free rate per annum compounded continuously is
constant at r.
(a) For the special case where t
1
= T, what option strategy is a chooser option equivalent
to? Discuss briey one advantage and one disadvantage of the strategy. [6 marks]
(b) Determine the time-0 price of the chooser option in terms of the time-0 price(s) of
appropriate call and/or put option(s). Specify the strike price(s) and maturity date(s)
of the option(s) involved. [5 marks]
(c) Suppose r = 0, K = $30, t
1
= 2 years and T = 6 years. Now you are given the following
time-0 prices: the stock is selling at $32; the price of the chooser option is $10.48; and a
call option with strike price $30 and maturity date 2 years from now is selling at $4.89.
Determine the time-0 price of a put option with strike price $30 and maturity date 6
years from now. [3 marks]
[Total: 14 marks]
Solution. (a) The payo at time t
1
= T of the chooser option is
max{(S
T
K)
+
, (K S
T
)
+
} =
_
K S
T
, if S
T
< K
S
T
K, if S
T
K
= |S
T
K|,
which is the payo of longing a European call option as well as a European put option,
both with the same strike price K and maturity date T, or a straddle.
Advantage: Payo is independent of the direction of the stock price movement / The
option holder can prot from price movements in both directions.
Disadvantage: It requires heavier investment (both call and put need to be bought).
(b) Hint: Try to rewrite the unfamiliar payo function of the chooser option in terms of
familiar payo functions, e.g. those of call and put.
Let C(S
t
, t, T) and P(S
t
, t, T) denote the time-t prices of a European call and European
put option on the stock, both with maturity date T and strike price K. The payo of
the chooser option at time t
1
is
max {C(S
t
1
, t
1
, T), P(S
t
1
, t
1
, T)} = max {C(S
t
1
, t
1
, T) P(S
t
1
, t
1
, T), 0} + P(S
t
1
, t
1
, T)
= max
_
S
t
1
Ke
r(Tt
1
)
_
+ P(S
t
1
, t
1
, T), (2)
where the last equality follows from the put-call parity. Note that max
_
S
t
1
Ke
r(Tt
1
)
_
is the payo of a European call option written on the stock expiring at time t
1
with a
strike price of Ke
r(Tt
1
)
. By discounting (2) to time 0, the time-0 price of the chooser
option is a sum of:
The time-0 price of the above European call option, i.e. written on the stock
expiring at time t
1
with a strike price of Ke
r(Tt
1
)
.
The time-0 price of a European put option written on the stock expiring at time
T with a strike price of K .
Remark 4. Why did I write
max {C(S
t
1
, t
1
, T), P(S
t
1
, t
1
, T)} = max {C(S
t
1
, t
1
, T) P(S
t
1
, t
1
, T), 0} + P(S
t
1
, t
1
, T)
instead of
max {C(S
t
1
, t
1
, T), P(S
t
1
, t
1
, T)} = C(S
t
1
, t
1
, T)+max {P(S
t
1
, t
1
, T) C(S
t
1
, t
1
, T), 0}?
Because...I peeked at part (c) and saw that the price of a put expiring at time T will
be calculated at the end! So, the rst writing will be more useful later!
(c) Because r = 0, Ke
r(Tt
1
)
= K = 30, so that the call option and put option comprising
the price of the chooser option (result in (b)) have the same strike price. Using the
given option prices,
10.48 = 4.89 + P
P = 5.59
Remark 5. The fact that S
0
= 32 is not needed here.
Remark 6. A similar question is Question 4 (actually an Exam MFE sample question) in
STAT2820 December 2009 Examination.
3.5 The Binomial Tree Model (OPTIONAL)
1. Straddle
For a one-year straddle on a nondividend-paying stock, you are given: SOA
MFE
Spring
2007 Q14
(Adapted)
The straddle is constructed by a long position in a call option and a long position in
a put option, both of which are written on the same underlying stock, have the same
maturity of 1 year and the same strike price of $50.
The straddle can only be exercised at the end of one year.
The stock currently sells for $60.
In one year, the stock will either sell for $70 or $45.
Calculate the current price of the straddle by
(a) replicating the straddle by a portfolio of stock and cash;
(b) using risk-neutral valuation.
Solution. The payo of the straddle is given by the absolute value of the dierence between
the strike price and the stock price at expiration date:
(S(1) 50)
+
+ (50 S(1))
+
= |S(1) 50|.
The binomial tree is constructed in Figure 3 with the payos of the derivative shown in
parenthesis.
S
0
= 60
S
u
= 70 (20)
q
=
0
.
7
9
9
9
S
d
= 45 (5)
1
q
=
0
.
2
0
0
1
Figure 3: Binomial tree for Question 1
(a) Consider a replicating portfolio consisting of shares of stock and amount of cash.
Matching the payos in the up and down movements,
_
70 + e
0.08
= 20,
45 + e
0.08
= 5,
which gives = 0.6 and = 20.3086. The current price of the derivative is the same
as the portfolio value at time 0, which is
60(0.6) + (20.3086) = 15.6914 .
(b) The risk-neutral probability of an up movement is
q =
60e
0.08
45
70 45
= 0.7999.
Using risk-neutral valuation, the current price of the straddle is
e
0.08
[20q + 5(1 q)] = 15.6914 .
2. Modification to the Binomial Tree
The following one-period binomial stock price model was used to calculate the price of a SOA
MFE
Spring
2009 Q7
(Extended)
one-year 10-strike call option on the stock.
S
0
= 10
S
u
= 12
S
d
= 8
You are given:
The period is one year.
The true probability of an up-move is 0.75.
The stock pays no dividends.
The price of the one-year 10-strike call is $1.13.
Upon review, the analyst realizes that there was an error in the model construction and
that S
d
, the value of the stock on a down-move, should have been 6 rather than 8. The true
probability of an up-move does not change in the new model, and all other assumptions were
correct.
(a) Recalculate the price of the call option.
(b) Comment on the new price in (a).
Solution. (a) We can perform risk-neutral valuation to deduce the value of e
r
, which
remains the same after the model review:
e
r
[q(2) + (1 q)(0)] = 1.13
e
r
_
2
_
10e
r
8
12 8
__
= 1.13
e
r
= 0.9675.
After the model review, the risk-neutral probability becomes
q
=
10e
r
6
12 6
= 0.7226.
The new price of the call option is then e
r
(2q
) = 1.3983 .
(b) The new price is higher. Note that q, as a function of the down movement, d, is
decreasing, because
q =
e
r
d
u d
=
e
r
u
u d
+ 1,
which decreases with d as e
r
< u. This means a decrease in d will result in an increase
in q. With a higher probability (in the risk-neutral world) of being in the money, the
call will have a higher price.
Remark 7. The true probability of an up-move is designed by the SOA to distract you!
3. Three-State World SOA
Exam
MFE
Sample
Q27
You are given the following information about a securities market:
There are two nondividend-paying stocks, X and Y .
The current prices for X and Y are both $100.
There are three possible outcomes for the prices of X and Y one year from now:
Outcome X Y
1 $200 $0
2 $50 $0
3 $0 $300
Let C
X
be the price of a European call option on X, and P
Y
be the price of a European put
option on Y . Both options expire in one year and have a strike price of $95.
Using the method of replicating portfolio, calculate P
Y
C
X
.
Solution. Although there are three possible outcomes, the philosophy of the method of repli-
cating portfolio is exactly the same as that in the binomial model.
The payo associated with buying a put option on Y and selling a call option on X, both
expiring in one year with strike price of $95, is given by:
Outcome Payo of Put Payo of Call Total Payo
1 (95 0)
+
= 95 (200 95)
+
= 105 10
2 (95 0)
+
= 95 (50 95)
+
= 0 95
3 (95 300)
+
= 0 (0 95)
+
= 0 0
Consider a portfolio consisting of amount of cash, shares of X and shares of Y . To
replicate the above payo structure, we solve
_
_
e
0.1
+ 200 = 10,
e
0.1
+ 50 = 95,
e
0.1
+ 300 = 0,
which gives = 117.6289, = 0.7 and = 13/30. Hence
P
Y
C
X
= + 100 + 100 = 4.2955 .
Remark 8. Stocks X and Y can be said to be mutually exclusive, in that whenever one of
them has a positive price, then the price of other must be zero.
Epilogue
Option pricing is indisputably a topic of paramount importance in risk management and actu-
arial science. For this reason, many courses in our department cover option pricing, though to
dierent extent. If you are interested, you may try the following additional past paper questions
from other STAT courses.
Course Title Year Question
STAT2309 The Statistics of Investment Risk December 2008 4
STAT2807 Corporate Finance for Actuarial Science May 2007 7
May 2006 9
STAT2808 Derivatives Markets December 2008 3
STAT2812 Financial Economics I December 2009 1
STAT3303 Derivatives and Risk Management December 2010 1, 2
STAT3308 Financial Engineering December 2009 2
December 2008 3
May 2006 2 (a), 3 (b)
Table 1: Additional Relevant Past Examination Questions in STAT courses. Numerical answers
are available from the Statistics and Actuarial Science Society.
4 Farewell
Figure 4: So much for the hardship in my tutorials. For Year 2 students, see you in the next
semester if possible; for nal-year students, congratulations (in advance) on graduation!
Ambrose LO
Tutor of STAT2807 Corporate Finance for Actuarial Science (2011-2012)
********** END OF TUTORIAL 10 & THE WHOLE COURSE **********
Good Luck for Final Examination

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Second Semester, 2011-2012

THE UNIVERSITY OF HONG KONG

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