1.

If the volatility of a non-dividend-paying stock is 20% per annum and a risk-free rate is 5% per
annum, which of the following is closest to the Cox, Ross, Rubinstein parameter p for a tree
with a three-month time step?
A. 0.50
B. 0.54
C. 0.58
D. 0.62

Answer: B

The formula for p is

rΔt 0. 05×0 .25

e −d e −0 .9048
p= =
u−d 1 .1052−0. 9048 =0.538

2. The current price of a non-dividend paying stock is $50. Use a two-step tree to value an
American put option on the stock with a strike price of $48 that expires in 12 months. Each
step is 6 months, the risk free rate is 5% per annum, and the volatility is 20%. Which of the
following is the option price?
A. $1.95
B. $2.00
C. $2.05
D. $2.10

Answer: B

In this case
u=eσ √ Δt =e0 . 2× √ 0. 5 =1. 152 d=1/u=0. 868
rΔt 0 . 05×0. 5
e −d e −0 .868
p= = =0 . 5539
u−d 1 . 152−0 . 868
The tree is

66.34482
0
57.5955
0
50 50
1.999 0
43.40617
4.593828
37.68192
10.31808
3. Which of the following describes delta?
A. The ratio of the option price to the stock price
B. The ratio of the stock price to the option price
C. The ratio of a change in the option price to the corresponding change in the stock
price
D. The ratio of a change in the stock price to the corresponding change in the option
price

Answer: C

Delta is f/S where S is a small change in the stock price (with nothing else changing)
and f is the corresponding change in the option price.

4. When moving from valuing an option on a non-dividend paying stock to an option on a

currency which of the following is true?
A. The risk-free rate is replaced by the excess of the domestic risk-free rate over the
foreign risk-free rate in all calculations
B. The formula for u changes
C. The risk-free rate is replaced by the excess of the domestic risk-free rate over the
foreign risk-free rate for discounting
D. The risk-free rate is replaced by the excess of the domestic risk-free rate over the
foreign risk-free rate when p is calculated

Answer: D

The formula for u does not change. The discount rate does not change. The formula for
p becomes
( r−r f ) Δt
e −d
p=
u−d
showing that D is correct.

5. A tree is constructed to value an option on an index which is currently worth 100 and has a
volatility of 25%. The index provides a dividend yield of 2%. Another tree is constructed to
value an option on a non-dividend-paying stock which is currently worth 100 and has a
volatility of 25%. Which of the following are true?
A. The parameters p and u are the same for both trees
B. The parameter p is the same for both trees but u is not
C. The parameter u is the same for both trees but p is not
D. None of the above

Answer: C
The formula for u is the same in the two cases so that the values of the index on its tree
are the same as the values of the stock on its tree. However, in the formula for p, r is
replaced by r−q.