Indian Institute of Technology Jodhpur

Financial Engineering (SS457)

Semester I (2016)
Assignment II
1. Suppose you have just spoken to a bank about borrowing Rs 100,000 to purchase a
house, and the loan officer has told you that a Rs 100,000 loan, to be repaid in monthly
installments over 15 years with an interest rate 0.6% per month, could be arranged. If
the bank charges a loan initiation fee of Rs 600, a house inspection fee of Rs 400, and
1 point (1% of the nominal loan of Rs 100,000), what is the effective annual interest
rate of the loan being offered?
2. The average stock price for companies making up S & P 500 is 30 $ and the standard
deviation is 8.20$. Assume the stock prices are normally distributed. How high does a
stock price have to be to put a company in top 10%.
3. Suppose that X has normal distribution with mean and variance 2 , and let Y = eX .
(a) Determine the density of Y .
(b) Compute E(Y ) and V ar(Y ).
4. Starting at some fixed time, let S(n) denote the price of a certain security at the end
of n 1 additional weeks. A popular for the evolution of these prices assumes that
the price ratios S(n)/S(n 1) are iid log-normal random variables with parameters
= 0.0165 and = 0.073, what is the probability that
(a) the price of the security increases over each of the next two weeks
(b) the price at the end of two weeks is higher than it is today
5. Consider a 3-period model with t = 0, 1, 2, 3. There are a stock and a risk-free asset.
The initial stock price is 4$and the stock price doubles with probability 2/3 and one-half
with probability 1/3 each period. The risk-free rate is 1/4. Compute the risk neutral
probability at each node.
6. Let S(0) = 120, u = 1.2, d = 0.9 and r = 1% per annum. Consider a European call
option with strike price K = 120 and T = 2. Find the option price and the replicating
strategy.
7. Price an American put option having the following parameters
S(0) = 9,

t = 3months,

K = 10,

= 0.3,

r = 0.6,

n=5

8. Consider a stock with a volatility of its logarithm of = 0.20. The current price of
the stock is Rs 62. A certain European call option on this stock has an expiration date
5 months from now and a strike price of Rs 60. The current rate of interest is 10%,
compounded monthly. Determine the price of this call by using the binomial option
approach.
9. Consider a three period model with S0 = 4, u = 2, d = 1/2 and take the interest rate
P
r = 1/4. For n = 0, 1, 2, 3, define Xn = nk=0 Sn . Consider an Asian call option that
expires at time three and has strike price K = 4, that is, whose payoff at time three is
( 41 X3 4)+ . Let vn (s, x) denote the price of this option at time n if Sn = s and Xn = x.
In particular, v3 (s, x) = ( 41 x 4)+ .
(i) Develop an algorithm for computing vn recursively. In particular, write a formula
for vn in terms of vn+1 .
(ii) Apply the above algorithm to compute the price of the Asian option at time zero.
(iii) Provide a formula for the number of shares of stock that should be held by the
replicating portfolio at time n if Sn = s and Xn = x.
10. In a Binomial market model with parameters S0 = 1, u = 2, d = 1/2, r = 0 and N = 2,
consider an Asian Put option with floating strike and payoff
X = (M SN )+ ,

where M =

S0 + S1 + S2
3

Determine the price process, denoted by (An ) and the hedging strategy for n = 0, 1.