Prof.

Roberto Steri Derivatives I - Problem Set 7 Spring 2019

Problem Set 7
Suggested Deadline: 10/05/2019

Option Pricing: Multi-Period Financial Market Model

1
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

1. Consider a multi-period …nancial market with t = 0; 1; 2 and with the following information
structure:
t=0 t=1 t=2

% !1
f11
& !2
%
f10
&
% !3
f21
& !4
In this market two securities are traded. The …rst is a locally riskless security B that provides
the following one-period interest rates:
r(0) = 25%
r(1)(f11 ) = 20%
r(1)(f21 ) = 25%

The second security is a risky security S whose price is S(0) = 1 at time t = 0, while at time
t = 1 we have
S(1)(f11 ) = S(0) u
S(1)(f21 ) = S(0) d
and …nally at time T = 2 we have
S(2)(! 1 ) = S(1)(f11 ) u
S(2)(! 2 ) = S(1)(f11 ) d
S(2)(! 3 ) = S(1)(f21 ) u
S(2)(! 4 ) = S(1)(f21 ) d
where u = 1:5 and d = 0:8:

a) Write explicitly the prices for B; S at t = 1; 2:

b) Is the multi-period market dynamically complete?
c) Is the multi-period market arbitrage-free? If the answer is positive …nd the risk neutral
probabilities Q for the multi-period market, specifying Q(! k ) for k = 1; :::; 4:
d) Assume that an European lookback call with payo¤ at maturity T = 2 given by:
X(2) = max S(t) S(2)
t=0;1;2

is introduced in the market. Determine its no-arbitrage price in t = 0 and in the two
states in t = 1.

2
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

e) A European call knock-in option with strike K = 1 and barrier b = 0:9 pays at its
maturity T = 2 the payo¤ max(S(2) K; 0) if during the life of the option the security
price S falls strictly below the barrier b: The …nal payo¤ is zero if during the life of the
option the security price S lies always above or on the barrier b: More precisely, the
payo¤ at maturity of the call knock-in option is
(
max(S(2) K; 0) if min S(t) < b
X(2) = t=0;1;2
0 otherwise

Write the payo¤ at maturity of the call knock-in option, X(2); in any node ! k for
k = 1; :::; 4: Determine the no arbitrage price of the call knock-in option at t = 0 and in
the nodes f11 and f21 at time t = 1.

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Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

Solution.

a) The prices of the locally riskless asset B are:

B(0) = 1

B(1)(f11 ) = 1 + r(0) = 1:25

B(1)(f21 ) = 1 + r(0) = 1:25
B(2)(! 1 ) = B(1)(f11 ) [1 + r(1)(f11 )] = 1:5
B(2)(! 2 ) = B(1)(f11 ) [1 + r(1)(f11 )] = 1:5
B(2)(! 3 ) = B(1)(f21 ) [1 + r(1)(f21 )] = 1:5625
B(2)(! 4 ) = B(1)(f21 ) [1 + r(1)(f21 )] = 1:5625
The prices of the risky asset S are:

S(0) = 1

S(1)(f11 ) = S(0) u = 1:5

S(1)(f21 ) = S(0) d = 0:8
S(2)(! 1 ) = S(1)(f11 ) u = 2:25
S(2)(! 2 ) = S(1)(f11 ) d = 1:2
S(2)(! 3 ) = S(1)(f21 ) u = 1:2
S(2)(! 4 ) = S(1)(f21 ) d = 0:64
b) The market is dynamically complete because every submarket is complete. In fact, for
every submarket, the rank of the payo¤ matrix is equal to the number of states at the
end of the period.

m0
f11 m1;1 m1;2
% !1 !3
% %
f10 f11 f21
& !2 & !4
&
f21

In fact, for market m0 we have

1:25 1:5
Rank =2
1:25 0:8
and for market m1;1
1:5 2:25
Rank =2
1:5 1:2

4
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

and for market m1;2

1:5625 1:2
Rank =2
1:5625 0:64
c) By the …rst fundamental theorem of asset pricing the market is arbitrage free if there
exists an equivalent martingale measure. In order to work out risk neutral probabilities,
we solve the following systems:
8
> 1 1 1 1 1
< S(0) = 1+r(0) fS(1)(f1 )Q[f1 ] + S(1)(f2 )Q[f2 ]g
Q[f11 ] + Q[f21 ] = 1 (1)
>
: Q[f 1 ]; Q[f 1 ] > 0
1 2

for m0 ;
8
1 1 1 1
>
< S(1)(f1 ) = 1+r(1)(f11 ) fS(2)(! 1 )Q[! 1 jf1 ] + S(2)(! 2 )Q[! 2 jf1 ]g
Q[! 1 jf11 ] + Q[! 2 jf11 ] = 1 (2)
>
: Q[! jf 1 ]; Q[! jf 1 ] > 0
1 1 2 1

for m1;1 ; and

8
1 1 1 1
>
< S(1)(f2 ) = 1+r(1)(f21 ) fS(2)(! 3 )Q[! 3 jf2 ] + S(2)(! 4 )Q[! 4 jf2 ]g
Q[! 3 jf21 ] + Q[! 4 jf21 ] = 1 (3)
>
: Q[! jf 1 ]; Q[! jf 1 ] > 0
3 2 4 2

for m1;2 : Each system is based on the de…nition of Equivalent Martingale measure in the
one-period submarket, i.e. conditional on the information sets f10 , f11 , and f21 respectively.
Plugging the information about security prices into (1) we obtain
8 1 1 1
< 1 = 1:25 f1:5Q[f1 ] + 0:8Q[f2 ]g
Q[f11 ] + Q[f21 ] = 1
:
Q[f11 ]; Q[f21 ] > 0

which is solved by

Q[f11 ] = 0:6429;
Q[f21 ] = 0:3571:

System (2) is
8 1 1 1
< 1:5 = 1:2 f2:25Q[! 1 jf1 ] + 1:2Q[! 2 jf1 ]g
Q[! 1 jf11 ] + Q[! 2 jf11 ] = 1
:
Q[! 1 jf11 ]; Q[! 2 jf11 ] > 0

5
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

whose solution is

Q[! 1 jf11 ] = 0:5714;

Q[! 2 jf11 ] = 0:4286:

Finally, system (3)

8 1 1 1
< 0:8 = 1:25 f1:2Q[! 3 jf2 ] + 0:64Q[! 4 jf2 ]g
Q[! 3 jf21 ] + Q[! 4 jf21 ] = 1
:
Q[! 3 jf21 ]; Q[! 4 jf21 ] > 0
is solved by

Q[! 3 jf21 ] = 0:6429;

Q[! 4 jf21 ] = 0:3571:

Hence, the market is arbitrage free.We can now work out the risk-neutral probabilities
Q[! k ] for k = 1; :::; 4 as follows:

Q[! 1 ] = Q[f11 ] Q[! 1 jf11 ] = 0:6429 0:5714 = 0:36735

Q[! 2 ] = Q[f11 ] Q[! 2 jf11 ] = 0:6429 0:4286 = 0:27555
Q[! 3 ] = Q[f21 ] Q[! 3 jf21 ] = 0:3571 0:6429 = 0:22958
Q[! 4 ] = Q[f21 ] Q[! 4 jf21 ] = 0:3571 0:3571 = 0:12752

d) The payo¤ of the lookback call at T = 2 is equal to:

X(2)(! 1 ) = 2:25 2:25 = 0

X(2)(! 2 ) = 1:5 1:2 = 0:3
X(2)(! 3 ) = 1:2 1:2 = 0
X(2)(! 4 ) = 1 0:64 = 0:36

The no arbitrage price of the derivative in the node f11 is

1 1
SX (1)(f11 ) = E Q 1
X(2) f11 = (0:5714 0 + 0:4286 0:3) = 0:10715
1 + r(1)(f1 ) 1:2
and in the node f21
1 1
SX (1)(f21 ) = E Q 1
X(2) f21 = (0:6429 0 + 0:3571 0:36) = 0:10284:
1 + r(1)(f2 ) 1:25
Finally, at t = 0, we have
1 1
SX (0) = E Q SX (1) = (0:6429 0:10715 + 0:3571 0:10284) = 0:08449
1 + r(0) 1:25

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Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

e) The payo¤ of the call knock-in option at T = 2 is equal to:

X(2)(! 1 ) = 0
X(2)(! 2 ) = 0
X(2)(! 3 ) = max[S(2)(! 3 ) K; 0] = 0:2
X(2)(! 4 ) = max[S(2)(! 4 ) K; 0] = 0

The no arbitrage price of the call knock-in option in the node f11 is

1 1
SX (1)(f11 ) = E Q 1
X(2) f11 = (0:5714 0 + 0:4286 0) = 0
1 + r(1)(f1 ) 1:2

and in the node f21

1 1
SX (1)(f21 ) = E Q 1
X(2) f21 = (0:6429 0:2 + 0:3571 0) = 0:102 86
1 + r(1)(f2 ) 1:25

Finally, at t = 0, we have

1 1
SX (0) = E Q SX (1) = (0:6429 0 + 0:3571 0:102 86) = 0:02939
1 + r(0) 1:25

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Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

2. Consider a multiperiod discrete market with t = 0; 1; 2 with the following information struc-
ture:
t=0 t=1 t=2

% !1
f11
& !2
%
f10
&
% !3
f21
& !4
Two securities are traded in the market. The …rst is the locally risk-free asset B that provides
the locally riskless interest rate

r(0) = 25%
r(1)(f11 ) = 0%
r(1)(f21 ) = 20%:

The second security is the risky asset S; whose price at time 0 is S(0) = 2:6, whereas at t = 1
its prices are
S(1)(f11 ) = 4
S(1)(f21 ) = 2:5
and at the …nal date T = 2
S(2)(! 1 ) = 6
S(2)(! 2 ) = 3
S(2)(! 3 ) = 4
S(2)(! 4 ) = 2

a) Write the prices of the locally riskless asset B in each node of the information structure
for t = 1; 2:
b) Is the market dynamically complete?
c) Is the market free of arbitrage opportunities? If your answer is positive, determine the
risk neutral probabilities Q for the market. Specify Q(! k ) for k = 1; :::; 4:
d) A European call option is written on the security S with strike price K = 3 and maturity
T = 2. Write the payo¤ at maturity in all the nodes ! k for k = 1; :::; 4: Determine the
no arbitrage price of the put option at t = 0 and in the nodes f11 and f21 at t = 1.
e) A European put option is written on the security S with strike price K = 3 and maturity
T = 2. Write the payo¤ at maturity in all the nodes ! k for k = 1; :::; 4: Determine the
no arbitrage price of the put option at t = 0 and in the nodes f11 and f21 at t = 1.

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Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

f) A zero-coupon bond pays 3 at t = 2 in every state. Find a replicating portfolio (t) =

S (t) C (t) P (t) , t = 0; 1, for the zero-coupon bond in terms of the risky asset,
the call option, and the put option. Determine its no arbitrage price at t = 0 and in the
nodes f11 and f21 at t = 1.

Solution.

a) The prices of the locally riskless asset B are:

B(0) = 1

B(1)(f11 ) = 1 + r(0) = 1:25

B(1)(f21 ) = 1 + r(0) = 1:25
B(2)(! 1 ) = B(1)(f11 ) [1 + r(1)(f11 )] = 1:25
B(2)(! 2 ) = B(1)(f11 ) [1 + r(1)(f11 )] = 1:25
B(2)(! 3 ) = B(1)(f21 ) [1 + r(1)(f21 )] = 1:5
B(2)(! 4 ) = B(1)(f21 ) [1 + r(1)(f21 )] = 1:5
b) The market is dynamically complete because every submarket is complete. In fact, for
every submarket, the rank of the payo¤ matrix is equal to the number of states at the
end of the period.

m0
f11 m1;1 m1;2
% !1 !3
% %
f10 f11 f21
& !2 & !4
&
f21

In fact, for market m0 we have

1:25 4
Rank =2
1:25 2:5

and for market m1;1

1:25 6
Rank =2
1:25 3
and for market m1;2
1:5 4
Rank =2
1:5 2

9
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

c) By the …rst fundamental theorem of asset pricing the market is arbitrage free if there
exists an equivalent martingale measure. In order to work out risk neutral probabilities,
we solve the following systems:
8
> 1 1 1 1 1
< S(0) = 1+r(0) fS(1)(f1 )Q[f1 ] + S(1)(f2 )Q[f2 ]g
Q[f11 ] + Q[f21 ] = 1 (4)
>
: Q[f 1 ]; Q[f 1 ] > 0
1 2

for m0 ;
8
1 1 1 1
>
< S(1)(f1 ) = 1+r(1)(f11 ) fS(2)(! 1 )Q[! 1 jf1 ] + S(2)(! 2 )Q[! 2 jf1 ]g
Q[! 1 jf11 ] + Q[! 2 jf11 ] = 1 (5)
>
: Q[! jf 1 ]; Q[! jf 1 ] > 0
1 1 2 1

for m1;1 ; and

8
1 1 1 1
>
< S(1)(f2 ) = 1+r(1)(f21 ) fS(2)(! 3 )Q[! 3 jf2 ] + S(2)(! 4 )Q[! 4 jf2 ]g
Q[! 3 jf21 ] + Q[! 4 jf21 ] = 1 (6)
>
: Q[! jf 1 ]; Q[! jf 1 ] > 0
3 2 4 2

for m1;2 : Each system is based on the de…nition of Equivalent Martingale measure in the
one-period submarket, i.e. conditional on the information sets f10 , f11 , and f21 respectively.
Plugging the information about security prices into (4) we obtain
8 1 1 1
< 2:6 = 1:25 f4Q[f1 ] + 2:5Q[f2 ]g
Q[f11 ] + Q[f21 ] = 1 (7)
: 1 1
Q[f1 ]; Q[f2 ] > 0

which is solved by

Q[f11 ] = 0:5;
Q[f21 ] = 0:5:

System (5) is
8 1 1
< 4 = 6Q[! 1 jf1 ] + 3Q[! 2 jf1 ]
Q[! 1 jf11 ] + Q[! 2 jf11 ] = 1
:
Q[! 1 jf11 ]; Q[! 2 jf11 ] > 0
whose solution is
1
Q[! 1 jf11 ] = ;
3
2
Q[! 2 jf11 ] = :
3

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Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

Finally, system (6)

8 1 1 1
< 2:5 = 1:2 f4Q[! 3 jf2 ] + 2Q[! 4 jf2 ]g
Q[! 3 jf21 ] + Q[! 4 jf21 ] = 1
:
Q[! 3 jf21 ]; Q[! 4 jf21 ] > 0
is solved by

Q[! 3 jf21 ] = 0:5;

Q[! 4 jf21 ] = 0:5:

Hence, the market is arbitrage free.We can now work out the risk-neutral probabilities
Q[! k ] for k = 1; :::; 4 as follows:

Q[! 1 ] = Q[f11 ] Q[! 1 jf11 ] = 0:5 31 = 16

Q[! 2 ] = Q[f11 ] Q[! 2 jf11 ] = 0:5 32 = 13
Q[! 3 ] = Q[f21 ] Q[! 3 jf21 ] = 0:5 0:5 = 41
Q[! 4 ] = Q[f21 ] Q[! 4 jf21 ] = 0:5 0:5 = 41

d) The payo¤ of call option at T = 2 is given by:

C(2)(! 1 ) = max[S(2)(! 1 ) K; 0] = 3
C(2)(! 2 ) = max[S(2)(! 2 ) K; 0] = 0
C(2)(! 3 ) = max[S(2)(! 3 ) K; 0] = 1
C(2)(! 4 ) = max[S(2)(! 4 ) K; 0] = 0

The no arbitrage price of the put option in the node f11 is

1 1 1 2
call(1)(f11 ) = E Q 1
P (2) f11 = 3+ 0 =1
1 + r(1)(f1 ) 1 3 3
and in the node f21
1 1
call(1)(f21 ) = E Q 1
P (2) f21 = (0:5 1 + 0:5 0) = 0:41667
1 + r(1)(f2 ) 1:2
Finally, at t = 0, we have
1 1
call(0) = E Q put(1) = (0:5 1 + 0:5 0:41667) = 0:56667
1 + r(0) 1:25

e) The payo¤ of the put option at T = 2 is given by:

P (2)(! 1 ) = max[K S(2)(! 1 ); 0] = 0

P (2)(! 2 ) = max[K S(2)(! 2 ); 0] = 0
P (2)(! 3 ) = max[K S(2)(! 3 ); 0] = 0
P (2)(! 4 ) = max[K S(2)(! 4 ); 0] = 1

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Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

The no arbitrage price of the put option in the node f11 is

1 1 1 2
put(1)(f11 ) = E Q 1
P (2) f11 = 0+ 0 =0
1 + r(1)(f1 ) 1 3 3
and in the node f21
1 1
put(1)(f21 ) = E Q 1
P (2) f21 = (0:5 0 + 0:5 1) = 0:41667
1 + r(1)(f2 ) 1:2
Finally, at t = 0, we have
1 1
put(0) = E Q put(1) = (0:5 0 + 0:5 0:41667) = 0:16667
1 + r(0) 1:25
f) By the put-call parity:
zcb(t) = S(t) + put(t) call(t)
which implies that the replicating strategy is not time varying and is
2 3 2 3
S 1
4 C 5 = 4 15
P 1
Alternatively, the replicating portfolio can be computed directly as:
2 3 2 3
6 3 0 2 3 3
6 7 S 6 7
63 0 07 4 5 637
6 7 C =6 7
44 1 05 435
P
2 0 1 3
which yields
2 3 32
S 1
4 C 5 = 4 15
P 1
The no arbitrage price of the ZCB in the node f11 is
1 1 1 2
zcb(1)(f11 ) = E Q 1
ZCB(2) f11 = 3+ 3 =3
1 + r(1)(f1 ) 1 3 3
and in the node f21
1 1
zcb(1)(f21 ) = E Q 1
ZCB(2) f21 = (0:5 3 + 0:5 3) = 2:5
1 + r(1)(f2 ) 1:2
Finally, at t = 0, we have
1 1
zcb(0) = E Q zcb(1) = (0:5 3 + 0:5 2:5) = 2:2
1 + r(0) 1:25

12
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

3. In a multi-period binomial market with terminal date T = 2, the following securities are
available for trading: a risk-free asset, yielding a riskless rate r = 5%; a risky security, S,
having initial value S(0) = 10 and single-period rate of increase (resp. decrease) u = 1:7
(resp. d = 0:8).

a) Determine the risk-neutral probability that the security S undergoes an increase between
time t and time t + 1, when NA holds. Compute also the risk-neutral probability that a
put option on S, with maturity T = 2 and strike price K = 16, is not exercised, i.e. it
expires out of the money at T = 2.
b) Compute the no-arbitrage price of the put option at the previous point and determine
the replicating strategy.
c) Suppose that at time t = 2; and only if the security S undergoes a decrease between
t = 0 and t = 1; it is possible for S to take an additional value at maturity, S(1) u+d
2
,
besides S(1)u and S(1)d. Is the market complete? Can the put option of the previous
point be replicated? What is the range of prices at which it is possible to buy/sell the
option at t = 0 without introducing arbitrage in the market?

Solution

a) The NA condition is satis…ed, because d = 0:8 < 1 + r = 1 + 0:05 < u = 1:7. As a result,
the risk-neutral probability of an increase is given by
1+r d
q= = 0:27778
u d
A put option on S with strike price K = 16 is out of the money at T = 2 if the security S
undergoes two upward shifts between t = 0 and T = 2, which happens with risk-neutral
probability equal to Q[! 1 ] = q q = 0:07716
b) The NA time-0 price of the put option is given by

max(K S(2); 0) 0 0:07716 + 2:4 0:4012345 + 9:6 0:521604

EQ 2
= = 5:41530
(1 + r) (1 + 0:05)2

The strategy replicating the put option can be found by determining = f (t)g1t=0 such
that
0 t=1
C (t) =
max(K S(2); 0) t=2

0 (1)
In particular, from the equality of the cash-‡ows at maturity we get (1) = ,
1 (1)
so that C (2) = A(1) (1) = max(K S(2); 0): In each of the two subtrees with roots fk1 ,

13
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

for k = 1; 2, such condition can be rewritten as

(1 + r)2 S(1)(fk1 )u 1
0 (1)(fk ) max(K S(1)(fk1 )u; 0)
=
(1 + r)2 S(1)(fk1 )d 1
1 (1)(fk ) max(K S(1)(fk1 )d; 0)

from which we obtain

1 u max(K S(1)(fk1 )d; 0) d max(K S(1)(fk1 )u; 0)
0 (1)(fk ) =
(1 + r)2 (u d)
and
1 max(K S(1)(fk1 )u; 0) max(K S(1)(fk1 )d; 0)
1 (1)(fk ) =
S(1)(fk1 )(u d)
Hence,for f11 where S(1)(f11 ) = 17 we obtain

1 1:7 max(16 17 0:8; 0) 0; 8 max(16 17 1:7; 0)

0 (1)(f1 ) = = 4:1118669
(1 + 0; 05)2 (1:7 0:8)
1 max(16 17 1:7; 0) max(16 17 0:8; 0)
1 (1)(f1 ) = = 0:1568627
17(1:7 0:8)
while for f21 where S(1)(f21 ) = 8 we get

1 1; 7 max(16 8 0:8; 0) 0; 8 max(16 8 1:7; 0)

0 (1)(f2 ) = = 14:512471
(1 + 0:05)2 (1:7 0:8)
1 max(16 8 1:7; 0) max(16 8 0:8; 0)
1 (1)(f2 ) = = 1
8(1:7 0:8)
In both nodes fk1 , because of the NA condition, we have that
max(K S(2); 0)
V (1) = 0 (1)(1 + r) + 1 (1)S(1) = EQ P1 ;
1+r
which in the two nodes corresponds to
0:27778 max(16 17 1:7; 0) + (1 0:27778) max(16 17 0:8; 0)
V (1)(f11 ) = =
(1 + 0:05)
= 1; 6507936
0:27778 max(16 8 1:7; 0) + (1 0:27778) max(16 8 0:8; 0)
V (1)(f21 ) = =
(1 + 0:05)
= 7:2380952

0 (0)
Finally, from condition C (1) = 0 we have (0) = , so that A(0) (0) = V (1),
1 (0)
i.e.
(1 + r) S(0)u 0 (0) V (1)(f11 )
= ;
(1 + r) S(0)d 1 (0) V (1)(f21 )

14
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

which can be solved to get

uV (1)(f21 ) dV (1)(f11 )
0 (0) = = 11:62341
(1 + r)(u d)
and
V (1)(f11 ) V (1)(f21 )
1 (0) = = 0:6208112
S(0)(u d)
The time-0 value of the strategy found is thus equal to V (0) = 0 (0) 1 + 1 (0) S(0) =
5:41530, coinciding with the time-0 no-arbitrage price of the put option.
c) The model is now modi…ed in the subtree with root f21 at time t = 1, since after the
node f21 the security S can take at time t = 2 also the value S(f21 ) u+d 2
= 10; besides
1 1
S(f2 )u = 13:6 and S(f2 )d = 6:4. The market is thus incomplete, because at time t = 1
only 2 securities are available for trading, while the possible scenarios at t = 2 following
f21 are actually 3: The put option of the previous point is redundant if there is such
that
0 t=1
C (t) =
max(K S(2); 0) t=2
The only change from the previous point is (the issue of existence and) the choice of
1
0 (1)(f2 )
(1)(f21 ) = 1 , which now has to verify
1 (1)(f2 )

2 3 2 3
(1 + r)2 S(1)(f21 )u 1 max(K S(1)(f21 )u; 0)
4 (1 + r)2 S(1)(f21 )d 5 0 (1)(f2 )
1 = 4 max(K S(1)(f21 )d; 0) 5
1 (1)(f2 )
(1 + r)2 S(1)(f21 ) u+d
2
max(K S(1)(f21 ) u+d
2
; 0)

The system is still solvable, since the rank of the matrix A(1)(f21 ) augmented with the
column vector of the put payo¤s in the nodes following f21 is equal to that of the matrix
A(1)(f21 ): Indeed, we have
2 3
1:1025 13:6 2:4
det 4 1:1025 6:4 9:6 5 = 0
1:1025 10 6

The choice (1)(f21 ) is still suitable for the replication of the option even when at ma-
turity the new scenario is revealed as true, as can be seen by the following equali-
ties: 0 (1)(f21 )(1 + r)2 + 1 (1)(f21 )S(1)(f21 ) u+d
2
= 14:51247 1:1025 1 10 = 6 =
1 u+d
max K S(1)(f2 ) 2 ; 0 : The replicating strategy is again unique, because the number
of unknowns, 2, is equal in each node to the number of linearly independent equations.
The time-0 no-arbitrage price of the put is unique and is equal (as in point 2) to the
value of the replicating strategy V (0) = 0 (0) 1 + 1 (0) S(0) = 5:41530: In order to

15
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

determine it, therefore, it is not necessary to identify the entire set of risk-neutral prob-
ability measures. However, we now derive it for exercise. Let us denote by ! 5 the new
scenario added to the four possible scenarios at maturity, denoted by ! 1 ; ::; ! 4 : The First
Fundamental Theorem of Asset Pricing ensures that Q [! 1 j P1 ] (f11 ) = q = 0:27778 and
Q [ ! 2 j P1 ] (f11 ) = 1 q = 0:72222, as at point 1. We now have to determine

Q [ ! k j P1 ] (f21 ) = qk0
P5 0
for k = 3; 4; 5, so as to have k =3 qk = 1 and

X
5
S(2)(! k )
S(1)(f21 ) = qk0 ;
k=3
1+r

i.e., setting q50 = 1 q30 q40 ; we have to determine q30 and q40 such that

S(1)(f21 ) u d d u u+d
S(1)(f21 ) = q30 + q40 + ;
1+r 2 2 2

which is a system admitting in…nite solutions. Let us then set q30 = q 0 , to obtain

2 u d u+d
q40 = 1+r q0
d u 2 2
2 u+d
q50 = 1 q30 q40 = 1 2q 0 1+r
d u 2

and, requiring the strict positivity of each qk0 ,

8
>
< q0 > 0
q 0 > 2(1+r) (u+d)
= 0:4444
>
: q 0 < 1 (1 2
u d

2 d u
(1 + r u+d2
) = 0:27778

i.e. q 0 2]0; 0:27778[: For each q30 = q 0 2]0; 0:27778[ we have that the following remains
constant h i
max(K S(1)(f21 )u;0) 0
EQ max(K S(2);0)
1+r(1)
P 1
1 (f2 ) = 1+r
q3 +
max(K S(1)(f21 )d;0) 0 max(K S(1)(f21 )0;5(d+u);0) 0
+ 1+r
q4 + 1+r
q5 = 7:238095
in the node f21 showing up at time t = 1 with risk-neutral probability 1 q: As a result,
the no-arbitrage price of the put option is at time t = 0 constantly equal to

1:6507936 q + 7:238095 (1 q)
= 5:41530
1+r

16
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

4. In a multi-period binomial market with terminal date T = 2 the following securities are
available for trade: a risk-free asset, B, yielding a riskless rate r = 8%; a risky security, S,
with initial value S(0) = 10 and single-period rate of increase (resp. decrease) u = 1:5 (resp.
d = 0:6).

a) Determine the risk-neutral probability that S decreases between time t and time t + 1,
when NA holds. In this case, compute the risk-neutral probability that at T = 2 the
security S takes the value S(2) = 9:
b) Compute the no-arbitrage price of a call option on S with maturity T = 2 and strike
price K = 7, and determine the replicating strategy.
c) If at t = 1 the rate for riskless lending/borrowing between time t = 1 and time t = 2 is
12% conditionally on S having increased in value between t = 0 and t = 1, is the market
still arbitrage-free? In case it is, determine the risk-neutral distribution of the pay-o¤ of
the call option of the previous point at time T = 2 and compute its no-arbitrage price
at time t = 1 in both nodes of the information structure.

Solution

a) The NA condition is satis…ed since d = 0:6 < 1 + r = 1 + 0:08 < u = 1:5. As a

consequence, the risk-neutral probability of an increase is
1+r d
q= = 0:53333
u d
The security S takes the value S(2) = 9 at time T = 2 after h increases between t = 0
and T = 2 have occurred, so that h must satisfy

9 = 10 uh d2 h
;

from which
h
1:5 9
= ;
0:6 10 0:62
that is
ln 10 90:62
h= =1
ln 1:5
0:6

(we could have got to the same conclusion by looking to the possible realizations of S(2)).
The probability required is then computed as follows

Q[S(2) = S(0)uh d2 h
] = 2 q (1 q) = 0:49778

17
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

b) The time-0 no-arbitrage price of the call option is given by

Q max(S(2) K; 0) 15:5 0:533332 + 2 0:49778 + 0 (1 0:53333)2

E = = 4:633440
(1 + r)2 (1 + 0:08)2

The replicating strategy can be found by looking for the strategy = f (t)g1t=0 such that

0 t=1
C (t) =
max(S(2) K; 0) t=2

0 (1)
In particular, from the equality of the cash‡ows at maturity we obtain (1) = ,
1 (1)
1
so that C (2) = A(1) (1) = max(S(2) K; 0): In both subtrees stemming from fk (with
k = 1; 2) such condition can be rewritten as

(1 + r)2 S(1)(fk1 )u 1
0 (1)(fk ) max(S(1)(fk1 )u K; 0)
= ;
(1 + r)2 S(1)(fk1 )d 1
1 (1)(fk ) max(S(1)(fk1 )d K; 0)
from which we get

max(S(1)(fk1 )u K; 0) S(1)(fk1 )u
det
1
max(S(1)(fk1 )d K; 0) S(1)(fk1 )d
0 (1)(fk ) = =
(1 + r)2 S(1)(fk1 )u
det
(1 + r)2 S(1)(fk1 )d

u max(S(1)(fk1 )d K; 0) d max(S(1)(fk1 )u K; 0)
=
(1 + r)2 (u d)
and
(1 + r)2 max(S(1)(fk1 )u K; 0)
det
1
(1 + r)2 max(S(1)(fk1 )d K; 0)
1 (1)(fk ) = =
(1 + r)2 S(1)(fk1 )u
det
(1 + r)2 S(1)(fk1 )d

max(S(1)(fk1 )u K; 0) max(S(1)(fk1 )d K; 0)
=
S(1)(fk1 )(u d)
Therefore, f11 when S(1)(f11 ) = 15 we obtain

1 1:5 max(15 0:6 7; 0) 0:6 max(15 1:5 7; 0)

0 (1)(f1 ) = = 6:001371
(1 + 0:08)2 (1:5 0:6)
1 max(15 1:5 7; 0) max(15 0:6 7; 0)
1 (1)(f1 ) = = 1;
15(1:5 0:6)

18
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

while for f21 when S(1)(f21 ) = 6 we obtain

1 1:5 max(6 0:6 7; 0) 0:6 max(6 1:5 7; 0)
0 (1)(f2 ) = = 1:143118
(1 + 0:08)2 (1:5 0:6)
1 max(6 1:5 7; 0) max(6 0:6 7; 0)
1 (1)(f2 ) = = 0:370370
6(1:5 0:6)
In both nodes f11 ; f21 , because of the NA condition, we have that
max(S(2) K; 0)
V (1) = 0 (1)(1 + r) + 1 (1)S(1) = EQ P1 ;
1+r
which in the two nodes corresponds to
0:533 max(15 1:5 7; 0) + (1 0:53333) max(15 0:6 7; 0)
V (1)(f11 ) = =
(1 + 0:08)
= 8; 518518
0:533 max(6 1:5 7; 0) + (1 0:53333) max(6 0:6 7; 0)
V (1)(f21 ) = =
(1 + 0:08)
= 0:987654
0 (0)
Finally, from condition C (1) = 0 we obtain (0) = so that A(0) (0) = V (1),
1 (0)
i.e. we get the system
" #" # " #
(1 + r) S(0)u 0 (0) V (1)(f11 )
= ;
(1 + r) S(0)d 1 (0) V (1)(f21 )
whose solution leads to
" #
V (1)(f11 ) S(0)u
det
V (1)(f21 ) S(0)d uV (1)(f21 ) dV (1)(f11 )
0 (0) = " # = = 3:73418
(1 + r) S(0)u (1 + r)(u d)
det
(1 + r) S(0)d
and
" #
(1 + r) V (1)(f11 )
det
(1 + r) V (1)(f21 ) V (1)(f11 ) V (1)(f21 )
1 (0) = " # = = 0:836762
(1 + r) S(0)u S(0)(u d)
det
(1 + r) S(0)d
The time-0 value of the strategy found is thus equal to V (0) = 0 (0) 1 + 1 (0) S(0) =
4:63344, i.e. it coincides with the time-0 no-arbitrage price of the option.

19
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

c) Now on the node f11 the interest rate r(1)(f11 ) = 12%, while at t = 0 and in node f21 the
rate is unchanged, since r(0) = r(1)(f21 ) = 8%. The market is then still arbitrage-free,
because
d = 0:6 < 1 + r(1)(f11 ) = 1:12 < u = 1:5
The risk-neutral probability of an increase between t = 1 and t = 2, conditionally on the
event f21 at time t = 1, is unchanged and we have

Q [S(2) = S(1)uj P1 ] (f21 ) = q = 0:53333;

while at the same time the following unconditional probability is unchanged:

Q [S(1) = S(0)u] = q = 0:53333

On the opposite, we have

Q [S(2) = S(1)uj P1 ] (f11 ) = q 0 ;

with q 0 such that

1 + r(1)(f11 ) d
q0 = = 0:57778
u d
As a result, this (random) variation of interest rates a¤ects the risk-neutral distribution
of the call option time-2 payo¤, leading to
8 q q 0 = 0:30814
>
> 15:5
>
>
< 2 q (1 q 0 ) = 0:225185
with
>
> 2 (1 q) q = 0:248888
>
>
:
0 (1 q)2 = 0:2177777
The no-arbitrage price of the option in the two nodes fk1 of the information structure at
time t = 1 is then
max(S(2) K; 0) max(15 1:5 7; 0)
EQ P1 (f11 ) = 0:57778 +
1 + r(1) (1 + 0:12)
max(15 0:6 7; 0)
+ (1 0:57778) = 8:75;
(1 + 0:08)
which is di¤erent from what obtained at the previous point, while
max(S(2) K; 0) max(6 1:5 7; 0)
EQ P1 (f21 ) = 0:5333 +
1 + r(1) (1 + 0:08)
max(6 0:6 7; 0)
+ (1 0:5333) = 0:98765;
(1 + 0:12)
which is the same as in the previous point.

20
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

5. Construct an Excel spreadsheet to answer the following questions in a binomial model with
t = 0; 1; 2; 3 (illustrated in the …gure below).

t=0 t=1 t=2 t=3

f13 = ! 1
%
f12
&
%
f11 f23 = ! 2
&
% %
f10 f22
& &
%
f21 f33 = ! 3
&
%
f32
&
f43 = ! 4

a) What is the current no-arbitrage price of a three-period European call option on the
stock that matures in the fourth period and with an exercise price of 51$? The binomial
model is calibrated to match the volatility of the underlying asset, and this yields a
riskfree rate of 4% per period, u = 1:2 and d = 0:9. The current underlying price is 48$.
b) Delta hedging for a long European call consists in constructing a riskless portfolio by going
short on the call and long (fwt ); w = 1; :::; jPt j; t = 0; 1; 2; 3 units of the underlying such
that the payo¤ of a riskless bond in obtained. The number (fwt ) of units to short is
given by the hedge ratio, is de…ned as the ratio of option payo¤ change over the stock
payo¤ change. What is the hedge ratio of the call option at the beginning of the …rst
period? Compute the price of a call option exploiting a portfolio with a long position in
(fwt ) stocks and a short position in one call option.
c) What is the current value of a three-period American put option with strike K = 37$,
calibrated such that the riskfree rate is 5% per period, u = 1:25 and d = 0:8, and with a
current stock price of 40$? In which nodes of the tree is it optimal to exercise the option?
Compute the early exercise premium for the American put at t = 0. What would be
the early exercise premium for an American call with the same strike, maturity, and
underlying of the American put?

21
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

Solution

a) The dynamic of the stock price is illustrated below:

The European call price can be computed either with risk-neutral valuation or with a
replicating strategy and it is reported below:

The price at t = 0 is therefore 6.357944$.

b) The hedge ratio is de…ned as:
t+1
C(t + 1)(fwt+1 ) C(t + 1)(fw+1 )
(fwt ) = t+1
S(t + 1)(fwt+1 ) S(t + 1)(fw+1 )
for; w = 1; :::; jPt j; t = 0; 1; 2; 3. Hedge ratios for the European call are reported below:

22
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

The hedge ratio of the call option at the beginning of the …rst period is therefore 0:648148.
It is straightforward to verify that, by construction, a portfolio long on (fwt ) shares and
short on one call is riskless1 , i.e.

S(t + 1)(flt+1 ) (fwt ) C(t + 1)(flt+1 ) = L

where L is constant for both l = w, and l = w + 1, that is for every possible future
outcome. Accordingly, at time t :

L
S(t)(fwt ) (fwt ) C(t)(fwt ) =
1+r

which implies that the price of the call option in the node fwt can be computed as:

L
C(t)(fwt ) = S(t)(fwt ) (fwt )
1+r

c) The value of the American put with early exercise is:

1
Since:
t+1 t+1
C(t+1)(fw ) C(t+1)(fw+1 )
(fwt ) = t+1
S(t+1)(fw t+1
) S(t+1)(fw+1 )
we have:
t+1 t+1
(fwt )S(t + 1)(fwt+1 ) (fwt )S(t + 1)(fw+1 ) = C(t + 1)(fwt+1 ) C(t + 1)(fw+1 )
that is:
t+1 t+1
(fwt )S(t + 1)(fwt+1 ) C(t + 1)(fwt+1 ) = (fwt )S(t + 1)(fw+1 ) C(t + 1)(fw+1 )
Meaning the the value of a portfolio long in (fwt ) stocks and short one call is constant, i.e.
t+1
V (t + 1)(fwt+1 ) = V (t + 1)(fw+1 )

23
Prof. Roberto Steri Derivatives I - Problem Set 7 Spring 2019

The value of and European put (i.e. without the possibility of early exercise) is given by:

Starting backwards from t = 3, in each node the value of the American put is the
maximum between the value with early exercise, i.e. max(K S(t)(fwt ); 0), and the
value in that node computed as usual. The following …gure reports the value of the
American put in each node, where in the nodes in green early exercise is optimal:

The initial put value is therefore 2:990466 $, and early exercise is optimal in nodes f12
(weakly), and in f32 . The early exercise premium is the di¤erence between the current
value of the American and the European puts with the same characteristics, that is
2:990466 2:674792 = 0:315 67 $. In the case of an American call with the same charac-
teristics the early exercise premium would be zero, since it is never optimal to exercise
it before maturity.

24