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Math 366 Winter 2021 Week 6 Assignment Solution

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11 views4 pages

Math 366 Winter 2021 Week 6 Assignment Solution

Uploaded by

Dave Hu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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4.

WEEK 6 ASSIGNMENT SOLUTION 73

Math 366 Winter 2021 Week 6 Assignment Solution

E XERCISE 6.1. A stock price is currently $100. Over each of the next
two six-month periods it is expected to go up by 10% or down by 10%. The
risk-free interest rate is 8% per year with continuous compounding. Use a
two-period binomial tree model to price a one-year European call option
with a strike price of $100.

S OLUTION . We S0 = 100, u = 1.1, d = 0.9. These data can be used to


set up the stock tree. We have r = 0.08/2 = 0.04 and R = e0.04 = 1.041. The
risk-neutral probability is
R−d 1.041 − 0.9
p∗ = = = 0.705.
u−d 1.1 − 0.9
The option tree can be constructed backwards from the payoff values by
using the formula
f u p ∗ + f d (1 − p ∗ )
f = .
R

E XERCISE 6.2. Calculate the replicating portfolio for the call option in
the above exercise.

S OLUTION . The replicating portfolio at a specific node of the binomial


tree is given by ( x, y), where x is the ∆ of the option, i.e., the relative change
of the option price with respect to the stock price:
fu − fd
x= .
Su − Sd
The value of the replicating portfolio at this node is xS + y, which should
be the same as the option value at this node, therefore
y = f − xS.
Using these two formulas, the replicating portfolio can be calculated at each
node independently.

E XERCISE 6.3. Use a 6-step binomial tree model to calculate the price of
a 6 month put option. Assume the following parameters:
S0 = 62, u = 1.06, d = 0.94, K = 60.
The annual interest rate is r = 15%. Note: Show all immediate results. You
can use software packages to aid your computations.
74 6. WEEK 6

S OLUTION . This should be done on a spreadsheet or you can do some


simple programming using whatever computer language and software you
know. I usually do it on Microsoft Excel. For the numerical project you will
be asked to implement binomial trees with up to 500 steps. This exercise is
just a warm up and you should work it out on your own independently.
The firs step is to construct the stock price tree using S0 , u, and d. You
will get 7 terminal values for the stock price at the end the 6 months period.
Then you calculate the payoff of the put option using the strike price K. Fill
the option tree terminal nodes with the values you thus obtained. Now
calculate the risk-neutral probability using the values of u, d, and R and fill
in the values of the option tree at each node until you reach the root. The
value at the root is the price of the option.

E XERCISE 6.4. A random variable X takes two values a and b with prob-
abilities
P[ X = a] = p, P[ X = b] = 1 − p.
Show that the variance of X is given by
σ 2 ( X ) = ( a − b )2 p (1 − p ).

S OLUTION . The variance of a random variable is defined by


σ2 X = E| X − EX |2 .
Expanding the square, we have
σ2 X = E| X |2 − (EX |)2 .
This last formula is usually more convenient for calculation than the first
one.
For the problem at hand, we have
EX = pa + (1 − p)b,
and
E| X |2 = pa2 + (1 − p)b2 .
Hence
σ2 X = pa2 + (1 − p)b2 − ( pa + (1 − p)b)2 (b − a)2 p(1 − p).

E XERCISE 6.5. If a random variable takes only two possible values 1


and −1. What is the maximum possible value of its variance σ2 ( X )?

S OLUTION . From the preceding exercise we have


σ2 X = (1 − (−1))2 p(1 − p) = 4p(1 − p).
4. WEEK 6 ASSIGNMENT SOLUTION 75

From calculus we know that the largest possible value for p(1 − p) is 1/4,
attained at p = 1/2. Hence the largest possible value of the variance is
4 · (1/4) = 1.

E XERCISE 6.6. The binomial distribution B(n; p) is defined by


 
n k
P { Zn = ka + (n − k )b} = p (1 − p)n−k , 0 ≤ k ≤ n.
k
Let
Zn = X1 + X2 + · · · + Xn ,
where { Xi } are independent and identically distributed random variables
with the Bernoulli distribution
P { X = a} = p, P { X = b} = 1 − p.
Show that Zn has the binomial distribution B(n; p).

S OLUTION . Zn = ka + (n − k )b if exactly k of the random variables


X1 , X2 , . . . , Xn is equal to a. Each choice of the random variables Xi to be
assigned the value a has the probability pk (1 − p)n−k by independence, and
there are (nk) mutually exclusive such choices. Therefore
 
n k
P { Zn = ka + (n − k )b} = p (1 − p ) n − k ,
k
which is exactly the binomial distribution.

E XERCISE 6.7. Let Zn has the binomial distribution B(n; p) defined in


the preceding exercise. What is the mean µ( Zn ) and the standard deviation
σ( Zn )?

S OLUTION . We have
n
Zn = ∑ Xk
k =1
as before. From probability theory, the mean value of a sum is equal to the
sum of the means. Therefore
n
EZn = ∑ EXk .
k =1
The random variables Xk have the same distribution, hence they have the
same mean value, which is pa + (1 − p)b. Hence
EZn = n( pa + (1 − p)b).
Again from probability theorem for a sum of independent random vari-
ables, the variance of the sum is equal to the sum of the variance. Hence
n
σ2 Zn = ∑ σ 2 Xk .
k =1
76 6. WEEK 6

The variance of Xk is (b − a)2 p(1 − p) as we have calculated before, hence


σ2 Zn = n(b − a)2 p(1 − p),
and the standard deviation is given by
√ q
2
σX = σ X = np(1 − p)|b − a|.

E XERCISE 6.8. If the monthly rate of return of a stock is 1% and the


monthly volatility is 0.08. What would be its annual rate of return and
volatility?

S OLUTION . The rate of return is scaled proportional of time length and


the volatility is scaled by the square root of the time lengths. Hence we
have
µ = 0.01 · 12 = 0.12
and √
σ = 0.08 · 12 = 0.277.

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