Week 4

CH 20 - 28. One strategy might be to buy what is called a straddlebuy a call

and a put with exercise price equal to the assets current price. If the asset
price does not change, both options become worthless. However, if the
price falls, the put will be valuable and, if price rises, the call will be
valuable. The larger the price movement in either direction, the greater the
profit.
If investors have underestimated volatility, the option prices will be too
low. Thus, an alternative strategy is to buy a call (or a put) and hedge
against changes in the asset price by simultaneously selling (or, in the
case of the put, buying) delta shares of stock.

Ch 21 - 17. a. P = 200 EX = 180 = 0.223 t = 1.0 rf = 0.21

d1 log[P/PV(E X)]/ t t /2
log[200/(1 80/1.21)]/ (0.223 1.0 ) (0.223 1.0 ) /2 1.4388
d2 d1 t 1.4388 (0.223 1.0 ) 1.2158

N(d1) = N(1.4388) = 0.9249

N(d2) = N(1.2158) = 0.8880
Call value = [N(d1) P] [N(d2) PV(EX)]
= [0.9249 200] [0.8880 (180/1.21)] = $52.88
b.
1 upside change u e h e0.223 1.0 1.2498
1 downside change d 1/u 1/1.2498 0.8001

Let p equal the probability that the stock price will rise. Then, for a risk-
neutral investor:
(p 0.25) + (1 p) (0.20) = 0.21
p = 0.91
In one year, the stock price will be either $250 or $160, and the
option values will be $70 or $0, respectively. Therefore, the value of
the option is:
(0.91 7 0) (0.09 0)
$52.64
1.21

c.
1 upside change u e h e0.223 0.5 1.1708
1 downside change d 1/u 1/1.1708 0.8541
 Let p equal the probability that the stock price will rise. Then, for a risk-
neutral investor:
(p 0.171) + (1 p) (0.146) = 0.10
p = 0.776

The following tree gives stock prices, with option values in

parentheses:

200
(52.63)
170.8 234.2
(14.11) (70.53)

145.9 200.0 274.2

(0) (20) (94.2)

Option values are calculated as follows:

(0.776 $20) (0.224 $ 0)
$14.11
1.10
1.

(0.224 $20) (0.776 $94.2)

$70.53
1.10
2.

(0.224 $14.11) (0.776 $70.53)

$52.63
1.10
3.

spread of possible option prices

Option delta
spread of possible stock prices

d. (i)
 70.53 14.11
Option delta 0.89
234.2 170.8

To replicate a call, buy 0.89 shares and borrow:

[(0.89 $170.8) $14.11]/1.10 = $125.37
94.2 20
Option delta 1.00
274.2 200

(ii)

To replicate a call, buy one share and borrow:

[(1.0 $274.2) $94.2]/1.10 = $163.64
20 0
Option delta 0 .37
200 145.9

(iii)

To replicate a call, buy 0.37 shares and borrow:

[(0.37 $200) $20]/1.10 = $49.09