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MGRM Case Study

MG Metal Hedging gone awry

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11 views5 pages

MGRM Case Study

MG Metal Hedging gone awry

Uploaded by

knk.nanda24
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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ANALYSIS & APPLICATION OF DERIVATIVES (FNCE658)

ASSIGNMENT 1 (INDIVIDUAL ASSIGNMENT)

(1)-A

Current stock price is $20 and the price may go up by 10% or


down by
10% at each time step. Each time step is 3 months and the risk-
free
rate is 12% p.a..

Using your 2-step binomial tree option pricing model, determine


the price of
a 6-month European call option with a strike of $21?

ANSWER: 6 month European call with strike of $21 is priced at 1.28$

Using your 2-step binomial tree option pricing model, determine


the price of
a 6-month American call option with a strike of $21?

ANSWER: 6 month American call with strike of $21 priced at 1.28$

The strike is now changed to $15, all other variables remain


unchanged.
What is the price of the European call option?

ANSWER: 3 month European call with strike of $15 is prices at 5.87$

What is the price of the American call option?

ANSWER: 3 month American call with strike of $15 is priced at 5.87$

(1)-B

Current stock price is $50 and the price may go up by 20% or


down by
20% at each time step. Each time step is 1 year and the risk-free
rate
is 5% p.a..
Using your 2-step binomial tree option pricing model, determine
the price of
a 2-year European put option with a strike of $52?

ANSWER: 2 year European put with strike of $52 is priced at 4.19$

Using your 2-step binomial tree option pricing model, determine


the price of
a 2-year American put option with a strike of $52?

ANSWER: 2 year American put with strike of $52 priced at 5.09$

The current stock price is now changed to $60, all other variables
remain unchanged.
What is the price of the European put option?

ANSWER: 2 year European put with strike of $52 is priced at 1.70$ (spot at 60)

What is the price of the American put option?

ANSWER: 2 year American put with strike of $52 priced at 1.70$

(1)-C

From the earlier exercises, what observations and insights can


you draw
from:
A European call option vis-a-vis an American call option? (2
observations/insights)

ANSWER:

The value of European call options & American Call options remain same
for a non-dividend paying stock when the option is in the money at $ 5.87

The value of European call options & American Call options remain same
for a non-dividend paying stock when the option is out of the money $
1.28

A European put option vis-a-vis an American put option? (2


observations/insights)
ANSWER:

The value of European put options & American put options remain same
for a non-dividend paying stock when the option is out of the money at $
1.70.
The value of European put options & American put options differs for a
non-dividend paying stock when the option is in the money or deep in the
money. American ITM Put is priced higher than a European ITM Put. This is
due to the exercising power of American put which gives it a higher value
due to its early exercise in the case where the intrinsic value is higher
than the risk neutral probability weighted average price discounted from
the next node.

ASSIGNMENT 2 (INDIVIDUAL ASSIGNMENT)

What is the price of a 6 month call option with a strike of $40?

ANSWER: $ 4.75942

What is the delta of the call option ?

ANSWER: 0.77913 (with a strike of $40)

What is the price of a 6 month put option with a strike of $40?


ANSWER: $ 0.80860

What is the delta of the put option?


ANSWER: -0.22087 (with a strike of $40)

If you are short the call option, how would you delta hedge your position?
ANSWER: To hedge a short call position we need to Long approximately
77.913 Shares per short call to delta hedge the postion.(Delta of call is
0.77913)(Assuming 1 option contract is for 100 shares of the underlying
asset)

NOW, Set the strike price of the option to equal the stock forward
price (6 month).
What are the call and put prices?
ANSWER: Call & Put prices were the same at $2.36762
What is this relationship?
ANSWER: This is due to the relationship between call & put prices
defined by Put Call Parity.
We define F = (S0*(𝑒^𝑟𝑇)) = K
The definition of Put-Call Parity states that (S0 + P) = (K(𝑒^-𝑟𝑇)) + C).
When F = (S0*(𝑒^𝑟𝑇)) =K, we can rearrange to S0 + P - C = K(𝑒^-𝑟𝑇))
Since S0 + P - C = S0, & Hence P = C.

What is the relationship between the level of volatility and both


the option prices?
ANSWER: If the volatility of the stock is higher it means the stock price
variation is higher & it transaltes to higher uncertainty which increases
the chance of an option ending up in the money(both call & put as
volatility considers both upside ad downside) & hence this gives an option
a higher value. Volatility & Options Prices of both Calls & Puts are
Positively correlated
What is the relationship between the risk-free rate and both the option prices?
ANSWER: Call prices & Risk free rates are positively correlated & Put
prices are negatively correlated. Because when Interest rates higher, then
the discounted value of the strike price becomes lower & Call price is
(S0*Nd1) minus (PV of K)*Nd2. Similarly for puts when Rates are higher
the the discouted value of the Strike price will be lower and puts are
priced by (Pv of K)*N(-d2) minus (S0*N*(-d1).

NOW, Set the spot price to $28 and the other variables to remain unchanged
(strike of $42, risk-free rate of 10%, volatility of 20% and time to maturity of 6
months)

Note the prices of the call and put options

ANSWER: When we set the spot price to $28 and other variables remain
unchanged, the call option price is $0.00907 and put option price is
$11.96071

Set the time to expiration to 3 months and 6 months and note the
respective option prices How would you characterise the time
value of the options? What would be an (intuitive) explanation?

ANSWER: When we set the spot price to $28 and change time to maturity
to 3 months, and other variables remain unchanged, the call option price
loses the residual time value and approaches towards the 0 (Intrinsic
Value), and put option price is $12.96 which is the

[(PV of K)*(N(-d2) minus S0*N(-d1)]

which is less in value today but increases in value as it reaches maturity


assuming spot is constant at 28, at maturity the Option will have Intrinsic
Value of 14 (this is the reason Deep ITM has positive Theta Value). We can
also intuitively explain positive theta, when the put is Deep in the money,
when the tenor is shorter there is a greater chance that the option
remains or expires in the money, when the Tenor is higher there is a
possibility that the stock price can increase & the option can become
OTM, so when the time to expiry increases it increases the risk of ending
up OTM, hence when time passes the deep in the money option gains in
value showing Positive theta.

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