FIN 550 Derivatives and Financial Risk Management

Assignment 2

Submission Deadline: May 22,2024

CLO2: Describe the mechanics of various types of derivatives including swaps, forwards,
futures, and options.
PLO1: To provide the students with knowledge of accounting and finance to manage and use
financial information.
CLO3: Apply different pricing models and valuation techniques to price and value derivative
instruments.
PLO2: To assess the financial well-being of organizations and make informed decisions,
effectively communicating findings to stakeholders.

Problem # 1

A stock currently trades at a price of $100. The stock price can go up 10 percent or down 15
percent. The risk-free rate is 6.5 percent.

A. Use a one-period binomial model to calculate the price of a call option with an exercise
price of $90.
B. Suppose the call price is currently $17.50. Show how to execute an arbitrage transaction
that will earn more than the risk-free rate. Use 1000 call options.
C. Suppose the call price is currently $14. Show how to execute an arbitrage transaction that
replicates a loan that will earn less than the risk-free rate. Use 1000 call options.

Problem # 2

Consider a two-period binomial model in which a stock currently trades at a price of $65. The
stock price can go up 20 percent or down 17 percent each period. The risk-free rate is 5 percent.

A. Calculate the price of a call option expiring in two periods with an exercise price of $60.
B. Based on your answer in Part A, calculate the number of units of the underlying stock
that would be needed at each point in the binomial tree to construct a risk-free hedge.
C. Calculate the price of a call option expiring in two periods with an exercise price of $70.
D. Based on your answer in Part C, calculate the number of units of the underlying stock
that would be needed at each point in the binomial tree to construct a risk-free hedge.

Problem # 3

Consider a two-period binomial model in which a stock currently trades at a price of $65. The
stock price can go up 20 percent or down 17 percent each period. The risk-free rate is 5 percent.

A. Calculate the price of a put option expiring in two periods with exercise price of $60.
B. Based on your answer in Part A, calculate the number of units of the underlying stock
that would be needed at each point in the binomial tree to construct a risk-free hedge.
C. Calculate the price of a put option expiring in two periods with an exercise price of $70.
 D. Based on your answer in Part C, calculate the number of units of the underlying stock
that would be needed at each point in the binomial tree to construct a risk-free hedge.

Problem # 4

Call and put options on an asset are available with an exercise price of $30. The options expire in
75 days, and the volatility is 0.40. The continuously compounded risk-free rate is 3.5 percent, and
there are no cash flows on the underlying. The precise Black-Scholes-Merton values of these
options at different underlying prices are as follows.

A. From the Black-Scholes-Merton model, obtain the approximate values of the call delta
and put delta if the underlying asset price is $28.
B. Using the call delta and put delta obtained in Part A and the call and put prices given in
the problem for the asset price of $28, calculate the approximate new call and put prices
for a
i. $1 increase in the price of the underlying asset
ii. $5 increase in the price of the underlying asset
C. Based on a comparison of your answers in Part B with the actual call and put prices given
in the problem, what can you say about the approximations based on delta?

Problem # 5

Consider an asset that trades at $100 today. Call and put options on this asset are available with
an exercise price of $100. The options expire in 275 days, and the volatility is 0.45. The
continuously compounded risk-free rate is 3 percent.

A. Calculate the value of European call and put options using the Black-Scholes- Merton
model. Assume that the present value of cash flows on the underlying asset over the life
of the options is $4.25.
B. Calculate the value of European call and put options using the Black-Scholes- Merton
model. Assume that the continuously compounded dividend yield is 1.5 percent.

Problem # 6

Consider the following information on put and call options on a stock:

Call price, co = $4.50

Put price, po = $6.80
Exercise price, X = $70
Days to option expiration = 139
Current stock price, So = $67.32
Risk-free rate, r = 5 percent

Use put-call parity to calculate prices of the following:

i. Synthetic call option

ii. Synthetic put option
iii. Synthetic bond
iv. Synthetic underlying stock
For each of the synthetic instruments in Part A, identify any mispricing by comparing the actual
price with the synthetic price.

Problem # 7

You are provided with the following information on put and call options on a stock:

Call price, co = $6.64

Put price, po = $2.75
Exercise price, X = $30
Days to option expiration = 219
Current stock price, So = $33.19

Put-call parity shows the equivalence of a call/bond portfolio (fiduciary call) and a put/underlying
portfolio (protective put). Illustrate put-call parity assuming stock prices at expiration (ST) of $20
and of $40. Assume that the risk-free rate, r, is 4 percent.

Problem # 8

Suppose a stock currently trades at a price of $150. The stock price can go up 33 percent or down
15 percent. The risk-free rate is 4.5 percent.

A. Use a one-period binomial model to calculate the price of a put option with exercise price
of $150.
B. Suppose the put price is currently $14. Show how to execute an arbitrage transaction that
will earn more than the risk-free rate. Use 10,000 put options.
C. Suppose the put price is currently $1 1. Show how to execute an arbitrage transaction that
will earn more than the risk-free rate. Use 10,000 put options.