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Problem Set 4/FIN4110: Black-Scholes

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Yahia Ezzat
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34 views1 page

Problem Set 4/FIN4110: Black-Scholes

Uploaded by

Yahia Ezzat
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Problem Set 4/FIN4110

Due: week 7
Options and Futures

CUHK(SZ)

Black-Scholes
Problem 1. (☀☀) Suppose that the Black-Scholes assumptions are satisfied. In particular, there is a stock
whose price follows a GBM with drift µ and volatility σ, and there is a money market account with
a constant instantaneous riskfree rate r. The stock does not pay any dividends before T . Consider a
derivative on the stock with payoff at time T , whose price at time t ≤ T is given by F (S, t). Recall that
the Black-Scholes PDE is
1
Ft (S, t) + rSFS (S, t) + σ 2 S 2 FSS (S, t) − rF (S, t) = 0
2
(a) Suppose
F (S, t) = e−r(T −t) [log S + (r − σ 2 /2) (T − t) − K]
for some parameter K. Is there an arbitrage opportunity?
(b) Suppose F (S, t) = e−r(T −t) S. Is there an arbitrage opportunity?

Problem 2. (☀☀) Answer the following questions in the context of the Black-Scholes model with a
non-dividend paying underlying.

(a) What is the delta of a long straddle position? (Recall that a long straddle is a long position in one
call and one put with the same strike price and maturity). What combination of a call and a put
with the same strike price and maturity achieves a delta of zero?
(b) What should be the instantaneous expected return on a zero-delta position? Justify your answer.
(c) Is the value of delta for an at-the-money call above, below or equal to 1/2 (prior to expiration)?
(d) Characterize analytically how the delta of a call option is affected by the volatility of the underlying.
Derive a condition on S/K which guarantees that the delta is increasing in the volatility parameter.
(e) Consider a derivative with payoff g (ST ) at time T . Suppose the volatility parameter σ is 22%,
and the riskfree rate r is 5%. The current value of the stock (at t = 0 ) is 100 , and the derivative
is worth 1.37 , with a delta of 0.175 , and a gamma of 0.017 . What is its theta?

Problem 3. (☀☀ ) A US bank’s position in options on the euro has a delta of 30,000 and a gamma of
-80,000. Explain how these numbers can be interpreted. The exchange rate (dollars per euro) is 0.90.
What position should the US bank take in the spot foreign exchange market to make the overall position
delta-neutral? After a short period of time, the euro appreciates to $0.93. Assuming the bank did
set up a delta-neutral position, how is the value of its overall position affected by the exchange rate
movement (use an approximation)? Estimate the new delta (of the original book of options). What
additional trade is necessary to keep the position delta-neutral?

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