Dartmouth College, Fall 2017

Mathematical Finance I, Math 86 S. Nanda

Assignment 3 Due: Oct 11 ,2017 in class

You may discuss the problems and solutions with anyone but the work written up and
submitted must be done on your own. Justify every step. Draw pictures where it helps to
illustrate.

1. Binomial Trees (also known as recombining trees) are a standard way to price options.
Use excel to create your binomial tree to the following specifications:

• Your tree should go out to 10 periods

• Your spreadsheet should be flexible enough that it can be expanded to include
more periods easily without recreating from scratch
• An important point when creating this binomial tree is to keep in mind that
a down-move followed by an up-move is the same as an up-move followed by a
down-move.
• It should be implemented purely in the risk-neutral world
• All time steps are of equal length
• Allow for inputting different parameter values like risk free rates, u, d, strike etc
• Your tree(s) should calculate any derivative price and delta at each node. Plan
the tree carefully.
• Put in formulas for pricing a European call or a put
• Assume no dividends
• Make good use of labeling and documentation so that its possible to understand
your tree
• Put your name in cell A1

Use the following file naming convention. name− binomialtree. eg janes− binomialtree.xls
for Jane Smith.
Submit your spreadsheet via Canvas (its working). This assignment may be used in
future homeworks Do not use visual basic.

2. A stock is worth 100 today. It will be worth either 90, 100 or 110 tomorrow. The call
option on this asset struck at 100 is worth 2. Give no-arbitrage price of a call option
struck at 105. Assume no interest rates.

3. A stock is worth 50 today. It is worth 40, 55, or 70 tomorrow. What are the possible
risk-neutral probabilities?
4. A stock price is worth 50 today. Over each of the next two three-month periods it
is expected to go up by 10% or down by 8%. What is the value today of a 6-month
european put struck at 51? Assume the risk free interest rate is 5% per anum with
continuous compounding. An American option is like a European option except that
it can be exercised anytime before expiration. From your calculations would it ever be
optimal to exercise the American put option early?

Note: Use the excel spreadsheet that you have created in problem 1 to do problem 4.