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RMSC2001 Fall 2022 Assignment 4

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16 views3 pages

RMSC2001 Fall 2022 Assignment 4

Uploaded by

fukchuntse
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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RMSC2001 Assignment 4

Deadline 18 Nov 2022


Question 1
We consider a European call and a European put option on an underlying asset
with the same strike price 𝐾𝐾 and maturity 𝑇𝑇. Let 𝑆𝑆𝑡𝑡 be the price of a unit of the
underlying asset at time 𝑡𝑡 and 𝑟𝑟 be the risk-free interest rate. 𝑡𝑡 = 0 is
considered the current time.
(a) By considering the following portfolios, show that
𝑐𝑐𝐸𝐸 (𝑡𝑡) ≥ max�𝑆𝑆𝑡𝑡 − 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) , 0�,
where 𝑐𝑐𝐸𝐸 (𝑡𝑡) is the price of the European call at time 𝑡𝑡.
A: Hold one European call and 𝐾𝐾 units of zero-coupon bonds
B: One unit of the underlying asset
(b) By considering the following portfolios, show that
𝑝𝑝𝐸𝐸 (𝑡𝑡) ≥ max�𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) − 𝑆𝑆𝑡𝑡 , 0�,
where 𝑝𝑝𝐸𝐸 (𝑡𝑡) is the price of the European put at time 𝑡𝑡.
A: Hold one European put and one unit of the underlying asset
B: 𝐾𝐾 units of zero-coupon bonds
(c) If 𝑆𝑆0 = $20, 𝐾𝐾 = $18, 𝑟𝑟 = 10%, 𝑇𝑇 = 1 year, what should an arbitrageur
do if the European call costs $3?
(d) If 𝑆𝑆0 = $37, 𝐾𝐾 = $40, 𝑟𝑟 = 5%, 𝑇𝑇 = 0.5 year, what should an arbitrageur
do if the European put costs $1?

Question 2.
Consider a portfolio consisting of a forward contract on an asset and a European
put option on the asset with the same maturity as the forward contract and a
strike price that is equal to the forward price of the asset at the time the
portfolio is set up. Show that the European put option has the same value as a
European call option with the same strike price and maturity.
Question 3.
A trader buys a call option with a strike price of $45 and a put option with a
strike price of $40. Both options have the same maturity. The call costs $3 and
the put costs $4. Draw a diagram showing the variation of the trader’s profit
with the asset price.

Question 4 (Optional, Difficult question).


Let 𝑐𝑐𝑡𝑡 (𝐾𝐾) be the price of a European call option with strike 𝐾𝐾 at time 𝑡𝑡. Let
𝐶𝐶𝑡𝑡 (𝐾𝐾) be the price of an American call option with strike 𝐾𝐾 at time 𝑡𝑡. The time
to maturity is at 𝑡𝑡 = 𝑇𝑇, the risk-free annually compounded interest rate is 𝑟𝑟. The
underlying security pays no dividends.
(a) Use a no-arbitrage argument to prove that 𝑐𝑐0 (𝐾𝐾) = 𝐶𝐶0 (𝐾𝐾).
(Hint: Consider two cases: when the American option does not exercise
early and when the American option is exercised at time 𝜏𝜏 ∈ (0, 𝑇𝑇))
(b) Comparing the payoffs of the following two portfolios, show that
𝑐𝑐𝑡𝑡 (𝐾𝐾) + 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) = 𝑝𝑝𝑡𝑡 (𝐾𝐾) + 𝑆𝑆𝑡𝑡 ,
where 𝑝𝑝𝑡𝑡 (𝐾𝐾) is the price of a European put option with strike 𝐾𝐾 at time 𝑡𝑡.
The time to maturity is at 𝑡𝑡 = 𝑇𝑇.
A: hold a call and 𝐾𝐾 units of zero-coupon bond
C: hold a put and one unit of stock
(c) Use the result of (a) and (b), show that
𝐶𝐶𝑡𝑡 (𝐾𝐾) − 𝑃𝑃𝑡𝑡 (𝐾𝐾) ≤ 𝑆𝑆𝑡𝑡 − 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) ,
where 𝑃𝑃𝑡𝑡 (𝐾𝐾) is the price of an American put option with strike 𝐾𝐾 at time
𝑡𝑡. The time to maturity is at 𝑡𝑡 = 𝑇𝑇.

(d) Comparing the following two portfolios, show that


𝐶𝐶𝑡𝑡 (𝐾𝐾) − 𝑃𝑃𝑡𝑡 (𝐾𝐾) ≥ 𝑆𝑆𝑡𝑡 − 𝐾𝐾.
E: A European call plus 𝐾𝐾 dollar cash
F: An American put plus one unit of stock
Both options share the same strike and maturity.
(Hint: Consider two cases: when the American option does not exercise
early and when the American option is exercised at time 𝜏𝜏 ∈ (0, 𝑇𝑇))
(e) The price of an American call on a non-dividend-paying stock is $4. The
stock price is $31, the strike price is $30, and the expiration date is in three
months. The risk-free interest rate is 8%. Derive upper and lower bounds
for the price of an American put on the same stock with the same strike
price and expiration date.

Question 5.
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
annum with continuous compounding. What is the value of a one-year European
call option with a strike price of $100?

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