Financial Instruments

Winter 2025
John Heaton

Homework 5
Due at the beginning of class 6

1 Multiperiod binomial tree

In each of the next two periods (i = 1 and i = 2), a stock whose value in period i = 0 is
S0 = 100, can either rise or fall by 10% (using the notation of the teaching notes, u = 1.1
and d = u1 ). Suppose the per-period risk-free rate is r = 5%. A financial intermediary
sold a European call option on the stock, with exercise price equal to K = 100.

1. What actions would the firm need to take in order to hedge its risk from writing
the call? (Tip: describe how you would set up a portfolio that the intermediary can
use to mirror the payoffs of the option. Note: answering that the firm can buy the
same call will not get full credit!)

(a) Using a two-period binomial tree, construct the replicating portfolio at each
node. How much would you charge for the call option at period i = 0?
What is the “delta” (the number of shares bought or sold in the replicating
portfolio) and how much borrowing or lending is required at each node?

(b) Let’s see what happens if we change the initial stock price S0 by a little.
In particular I would like you to figure out how the value of the replicating
portfolio changes when you change S0 . To do this compute the value of the
replicated portfolio, V RP when the initial stock price is equal to S0 + △S
with ∆S = 1, 2, ..., 10. When doing this remember that future stock prices
are also changed under the assumption that the stock price rises or falls by
10% going forward.
 i. Is the change in value of the portfolio linear in ∆S? (Tip: the change
in value is linear in ∆S if V RP (k · △S) = k · V RP (△S) ). Show your
calculations.
ii. If your answer in the previous point was “No”, would you describe the
relationship between V RP and S as concave or convex? What would be
the sign of the second derivative of a function V RP (S)?

(c) Use the initial assumption for S0 for this and the remaining questions.
Is the portfolio “self-financing”? (Tip: The portfolio is self-financing if you
do NOT need any additional capital infusion between period i = 0 and the
period of the final payoff T = 0 )

(d) What is the profit/loss on the replicating portfolio?

(e) What is the price of the call option if the stock pays a 5% dividend yield
in period i = 1? Show the resulting trees for the stock price and for the
option as well as your computations. (Hint: when the dividend is paid the
stock price must decline in response. In the “up” state in period 1 before the
dividend is paid, the stock prices is S0 × u. If y is the dividend yield, the
stock price next period in the “up” state after the payment of the dividend is
S0 × u × (1 − y). A similar adjustment must be made to the stock price in
the “down” state after the dividend is paid.)

(f) What is the price of the call option if the stock pays a $ 5 dividend in period
i = 1? In this case the dividend is a fixed dollar amount that is independent
of the stock price. Show the resulting trees for the stock price and for the
option as well as your computations. Comment on the difference with part
(e).

2 Black and Scholes (and Merton) Formula

Today is January 4, 2022. The stock price of Verotende Inc. (a well known publicly
traded investment bank in early 2022) is trading at at USD 42. In addition the annualized

2
stock return volatitiy is 20% and the annualized continuously compounded yield on 6
months T-bills is 10%.

1. Using the Black-Scholes formula, compute the price of a European call and a
European put option, with identical exercise price K c = K p = 40 dollars, and six
months to maturity. Show your calculations.

2. Compute the price of the call and put options using several initial stock prices
values, from 10% in the money to 10% out of the money. Plot the price of the the
two options as a function of the stock price in a chart. Would you describe the
relationship between the two option prices and S as concave or convex?

3. Consider changing the inputs: compute the price of the call and of the put using
different values for the parameters listed in the first column of Table (1). Report
your findings on the relationship between options prices and inputs, by filling the
white spaces in Table (1) (simply write: “increase”, “decrease” or “uncertain” in
each white space). Provide some intuition for your findings

If input increases...
Input Change in call price: Change in put price:

Stock Price
Strike Price
Volatility
Maturity
Risk free rate

Table 1: Sensitivity of Black and Scholes option prices to inputs

4. If you sell an at-the-money put option on Verotende Inc. to a counterparty, and

you want to hedge the short put using a position in stocks and bonds, what is
going to be your position in stocks and bonds?

3
3 Big binomial tree
Use the file BinomialTree.xls available on canvas to confirm that as you increase the
number of steps, the option price and delta from the Tree converges to the Black and
Scholes ones. Report the prices and deltas in a table for n = 2, 5, 10, 25, 50, 125, 250 tree
steps.