CAT 2

1. A “chooser” option is

Answer:

Given V 0=E Q [ Payoff at Maturity ] e−rt

Payoff of a chooser option=max [ C t , Pt ]

Therefore value of a chooser option will be given by

V 0= EQ [ max [ Ct , Pt ] ] e−rt

Taking T 1 as t∧T 2 as T :

Using the Put−call parity

Pt =Ct + K e−r (T −t¿)−S ¿t

Substituting the above equation gives

V 0= EQ ¿

V 0= EQ ¿

Given Ct is a constant ,

V 0=Ct e−rt + E Q ¿

C t e−rt is the price of a call option at time 0 ,C 0

V 0=C0 + EQ ¿

EQ ¿
−r ( T 2−T 1 )
V 0=C [ 0 , T 2 , K ] + P [0 ,T 1 , K e ]

In conclusion, the value of a chooser option is the sum of a call with strike price K and maturity
T 2 and a put with strike K e−r ( T −T ) and maturity T 1.
2 1

2.

ANSWER:

a. A binary option is an exotic option whose payoff is a fixed monetary amount or nothing at
all. The amount can be in the form of cash or the underlying asset.
b. Payoff – It is a fixed amount of cash, K, or nothing.

3. Barrier options:
a. They are either activated when a particular target is hit, knock – in barrier option, or ceases
to exist if a particular barrier is reached before maturity, knock – out barrier option. Payoff is
similar to a normal call or put option when exercised.
b. They are cheaper than normal options, this is because of higher risk to the holder.
 They are used to hedge a position but only if the investor believes the price will reach a
certain level.
An investor would buy a knock-in option if they were expecting significant price changes in
the underlying security. On the other hand, they would buy a knock-out option if they were
expecting small movements in the price.
c. Payoff of a knock in call option is given by:

{
Payoff = max ( S t−K , 0 ) , St > B
0 , otherwise
Payoff of a knock-out call option is given by:

Payoff =
{ 0 , St >B
max ( S t−K , 0 ) , otherwise
Adding the two options:

Payoff =
{max ( S t −K ,0 ) , St >B
max ( S t−K , 0 ) , otherwise
Which is similar to a European call option.
4. Math
n
Si
a. Saverage =∑ ,for discrete time
i=1 n
T
1
Saverage = ∫ S du, for continuous time.
n t u

Payoff of Asian put option = max (K−Saverage , 0)

b. Payoff of lookback put option = max ⁡( K−S min , 0)
Where K is strike price, Smin is the minimum value of the underlying and Saverage is the
average price of the underlying over time T.
5. Strategies
a. Straddle.
b. Go long for both call and put options with the same maturity and strike price.
81 72 87 77 77 67
c. Given u1= , d1= ,u 2= , d 2= ,u 3= , d 3= ,
76 76 81 81 72 72
'
Calculating the q s :
72
e0.05 −
76
q 1= =0.8774
81 72
−
76 76
0.05 77
e −
81
q 2= =0.8153
87 77
−
81 81
67
e 0.05−
72
q 3= =0.8692
77 67
−
72 72
 Price at time 0

[ ( 11∗0.8774∗0.8153 ) +( 1∗0.8774∗(1−0.8153 ) ) +( 1∗( 1−0.8774 )∗0.8692 ) +( 9∗( 1−0.8774 )∗( 1−0.869

d. A straddle is used when the share price is highly volatile, therefore the investor believes
there is going to be a huge change in the price but is unsure of the direction. If the expected
volatility is lower, the investor has no reason to hold the straddle hence should sell it.