RSM435:

Options and Futures

Group 4: Emanuele Delfino, Ivan Chu,
Lynda Chen, Oscar Chen, Sherry Li

November 12th, 2019

1
No Arbitrage Argument

· Portfolio: long Δ shares, short 1 option

· If the stock price increases, at time T

the value of the portfolio = S0uΔ - fu

If the stock price decreases, at time T

the value of the portfolio = S0dΔ - fd

S0uΔ - fu = S0dΔ - fd

· the PV of the portfolio = the cost of setting up the portfolio

=

· substitute Δ

2
Risk Neutral Valuation
● When valuing a derivative, we can assume that investors are risk neutral —> investors do
not increase the expected return they require from an investment to compensate for
increased risk
● Two features simplify the pricing of derivatives:
1. The expected return on a stock is the risk-free rate
2. The discount rate used for the expected payoff on an option is the risk-free rate
● Returning to equation p = (erT - d)/(u - d) in a risk neutral world we can consider p as the
probability of an upward movement in the underlying stock price

● Therefore the expression pfu+(1 - p)fd is the expected future payoff from the option

● Finally, we obtain the value of the option today by discounting the expected future payoff
at the risk free rate f = e-rT[(pfu + (1 - p)fd)]

To sum up, passages are: 1. Compute probabilities of different outcomes in a risk neutral world
2. Compute expected payoff from the derivative
3. Discount the expected payoff at the risk free rate

3
Question- Part 1

· The current stock price is $10.

· It will either go up to $12 or down to $9 three months from now.

· The risk-free rate of interest, expressed with continuous compounding, is 5 percent.

· The stock will not pay any dividends during the next three months.

Price a three-month European put option with an exercise price of $11 using both arbitrage
arguments and risk-neutral valuation.

4
Question 1
· S0 = 10;

· S0u = 12, S0d = 9

· rf = 5%

· T = 0.25;
· No dividends during the lifespan of the option

Price a three-month European put option with an exercise price of $11 using both arbitrage
arguments and risk-neutral valuation. (K = 11)

S0u = 12 u = S0/ 12 = 1.2

fu= max(K - ST, 0) = max(11-12, 0) = 0

S0 = 10

S0 d = 9 d = S0/ 9 = 0.9

fd= max(K - ST, 0) = max(11-9, 0) = 2

5
Q1 - No Arbitrage Argument
M1: no-arbitrage argument

long 2 shares
long 3 put

the PV of the portfolio = the cost of setting up the portfolio (no arbitrage)

f = 10 * (-⅔) - (12 * (-⅔) - 0)*e^(-0.05*0.25) = 1.2334

6
Q1 - Risk Neutral Valuation
M2: risk - neutral valuation
Question - Part 2
· The current stock price is $10.

· It will either go up to $12 or down to $9 three months from now.

· The risk-free rate of interest, expressed with continuous compounding, is 5 percent.

· The stock will not pay any dividends during the next three months.

1. Before you do any calculations, do you expect the option price to be higher or lower than
the option from the first part of the question (above)?
2. Do you know the delta of this option (without doing any calculations)?
3. Price a three-month European put option with an exercise price of $14 using both arbitrage
arguments and risk-neutral valuation.

8
Variables affecting option price
Variable European Call European Put

1. S0: Stock price today + -

2. K: exercise price - +

3. T: life of an option ? ?

4. σ: volatility of stock price + +

5. r: risk-free rate + -

6. d: dividends - +
Delta

● Delta is the ratio of the change in the price of the stock option to
the change in the price of the underlying stock.
● It is the number of stocks we would hold for each short option in
order to form a riskless portfolio.
● Delta is positive for call options and negative for put options.

10
Delta

S0u = 12 If K = $14, it is greater than both possibilities of

what the stock price would be at maturity.

S0 = 10 The put option would definitely be exercised at

maturity, providing a payoff of:

S0 d = 9

This is the same as the payoff of a short futures contract.

11
Q2 - No arbitrage argument
S0u = 12; fu= max(K - ST, 0) = max(14-12, 0) = 2
Risk-free rate of interest:
S0 = 10 5% (continuous)

Exercise price: $14

S0d = 9; fd= max(K - ST, 0) = max(14-9, 0) = 5

Confirming delta Option Value Calculation

Portfolio PV = Cost of setting up portfolio

12
Q2 - Risk-neutral valuation

13
Summary — Key Takeaways
- No Arbitrage Argument:

In a One-Step Binomial Model, the assumption of there is no arbitrage

opportunity:
● A risk-free portfolio (with two components: the stock and the
option) can be set up.
● Return of the portfolio = risk-free interest rate.

- Risk Neutral Valuation:

Investors are assumed to be risk neutral under this approach of valuing

an option price:
● P —> The probability of underlying stock price goes up
● Expected return = Risk-free interest rate
● Discount rate = Risk-free interest rate

14
Summary (Cont’d)
- Variables affecting European option price: 6 Variables

● Variables positively correlated with a European Call option price

(negatively correlated with a European Put option price):
○ S0: Stock price today
○ r : Risk-free rate
● Variables negatively correlated with a European Call option price
(positively correlated with a European Put option price):
○ K: Exercise price
○ d: Dividends
● σ: Volatility of stock price is positively correlated to both Call and Put options
● T: Life of an option
- Delta
● The ratio of the change in the price of the stock option to the change in the
price of the underlying stock.
● the number of stocks we would hold for each short option in order to form a
riskless portfolio.
● For Call options: Delta > 0, for Put options: Delta < 0

15
Thank you.
Any questions?

16