Chris Minwegen, Ben Campbell, Cooper Sampson

HW 10:

1.
You are looking at two-period binomial modeling for options on QED stock that expire in

1 year. You believe that the probability of an up movement in each 6-month period is

60% with an up factor of 1.08, and the probability of a down movement in each 6-month

period is 40% with a down factor of 0.96. The current stock price is $104 per share. The

annual risk-free rate is 1.8%, compounded continuously.

Calculate the prices of each option listed below given the conditions listed. The

conditions are only for that particular question... they do not apply to other problems (in

other words... if (a) has dividends, the dividend information does not apply to (b) unless

specifically stated). All options expire after 1 year (or two 6-month periods).

S = $104
U = 1.08
D = .96

In the first six month period, the $104 stock price goes up to $112.32 (60% chance) and down to
$99.84 (40% chance). In the next six month period, the $112.32 stock price goes up to $121.31
(60% chance) and down to $107.83 (40% chance). Also in the next six month period, $99.84
goes up to $107.83 (60% chance), and down to $95.85.

Risk free return for the first period= 1.009

1e^(.018*.5) = 1.009

Risk free return for the second period = 1.018

1e^(.018*.5) = 1.018

Risk Neutral Pricing

(1.009 - .96) / (1.08 - .96) = .408 down

(1.08 - 1.009) / (1.08 - .96) = .592 up

Total Probability:
Cuu = .3505
Cud = .4830
Cdd = .1665

a)
European call option with K = 100. No dividends.

S= $104
K = $100

Cuu = 121.31-100 = 21.31

Cud = 107.83 - 100 = 7.83
Cdd = 95.85 - 100 = -4.15 → 0

21.31 * .3505 = 7.47

7.83 * .4830 = 3.78
0 * .1665 = 0
7.47 + 3.78 = 11.25

11.25/ 1.018 = $11.05 → answer

b)
European put option with K = 115. No dividends.

S= $104
K= $115

Cuu = 121.31-115= 0
Cud = 107.83-115= 7.17
Cdd = 95.85 - 115= 19.15

0 * .3505 = 0
7.17 * .4830 = 3.46
19.15 * .1665 = 3.19
3.46 + 3.19 = 6.65

6.65/1.018 = $6.53
c)
American call option with K = 107. No dividends.

Cuu = 121.31 - 107 = 14.31

Cud = 107.83 - 107 = 0.83
Cdd = 0

Cu goes up to 14.31 or down to .83

14.31(.592) = 8.47
.83 (.408) = .34
8.47 + .34 = 8.81
8.81/1.009 = 8.73 → price of Cu
Intrinsic value
112.32-107 = 5.32

Cd goes up to .83 and down to 0

.83(.592) = .49
.49/1.009 = .485
Intrinsic value
99.84 - 107 = -7.16

Call Option Today

C goes up to 8.73 and down to .485

8.73 (.592) = 5.17

.485 (.408) = .197

5.17 + .197 = 5.37

5.37/1.009 = $5.32

d)
American put option with K = 99. No dividends.

Puu = 0
Pud = 0
Pdd = 95.85 - 99 = 3.15

Pu = 0
Intrinsic value =
99-112.32 = -13.32
PV of the option = 0

Pd goes up to 0 or down to 3.15

0(.592) = 0, 3.15(.408) = 1.29

Total cf = 1.29
1.29/1.009 = 1.28 → price of option Pd
Intrinsic value=

99 - 99.84 = -.84
Put Option Price today

P goes up to 0 and down to 1.28

13.32 (.592) = 0
1.28 (.408) = 0.52
.52/1.009 = $0.52

e)
American call option with K = 114. Cash dividend of $2 per share next period.

New two period binomial model with dividends

S= $104
Cu = (104-2)*1.08 = $110.32
Cd = (104-2)*.96 = $97.84
Cuu = $119.15
Cud = $105.91
Cdu = $105.67
Cdd = $93.93

Call option payoffs:

Cuu = 5.15
Cud = 0
Cdu = 0
Cdd = 0

Cu goes up to 5.15 and down to 0

5.15 (.3505) = 1.81

1.81/1.018 = 1.78
5.15 (.592) = 3.05
PV = 3.05/1.009 = 3.02

Intrinsic Value

112.32 - 114 = -1.68

Do not exercise early

Cd will have pv = 0
Intrinsic value
99.84 - 114 = -14.16

Price of the Call Option

Call goes up to 3.05 and down to 0
3.05 (.592) = 1.81
0 (.408) = 0
1.81/1.009 = $1.79

f)
American put option with K = 108. Continuous dividend yield of 3%.

S = 104
1.08
.96

- First things first, new risk neutral probabilities.

1.009*(1-.03) - .96 / (1.08-.96) = 0.16

1 - .16 = .84
Up = .16
Down = .84

Uu = .026
ud = .13
Dd = .71

Put expected cash flow

121.31 - 108 = 0
107.93 - 108 = .07
95.85 - 108 = 12.15
Pu:

0*(.16)+ .07(.84) = .058

PV = .059/1.009 = .0585

Intrinsic Value
K-S

108-112.32 = -4.32
We will not be exercising early

Pd:
.07 (.16) + 12.15 (.84) = 10.22

10.22/1.009
PV = 10.13

Intrinsic value:
99.84 - 108 = 0
108 - 99.84 = 8.16

Price of the Option:

P goes up to .06 and down to 10.13

.06 (.16) + 10.13 (.84) =

8.52

PV= 8.52/1.009 = $8.44