Lorenzo Bretscher Derivatives Spring 2022

1. This question asks you to price and describe the replicating portfolio for options on a non-
dividend-paying stock whose price is currently $16. The price evolves on a binomial tree as
follows:
36
↗
24
↗ ↘
16 18
↘ ↗
12
↘
9

The (continuously-compounded, annualized) interest rate is 10%. The time interval between
each stage is h = 6 months (ie, six months from today the price will be either 24 or 12; six
months later, it will be either 36, 18, or 9).

(a) What is the risk-neutral probability of an upward price move, p∗ ?

(b) Find the price of the following options:
i. An at-the-money European call expiring in 6 months.
ii. A European call with strike 17, expiring in 1 year.
iii. An American call with strike 17, expiring in 1 year.
iv. A European put with strike 17, expiring in 1 year.
(c) Find the delta, at each point in time, of the last two options in the previous part.
(d) You sell a European put with strike 17 to a customer at mid-market, assuming the above
binomial tree, and hedge appropriately. Six months pass, and volatility suddenly rises:
you now realize that the price will either double or halve. (So, if the price is 24, it will
now go to either 12 or 48 after a further six months; if the price is 12, it will go to either
24 or 6.) What effects does this have on your position? Be specific: think about things
like how your desired hedge changes, and the effect on your P&L.

1
Lorenzo Bretscher Derivatives Spring 2022

2. This question works with the spreadsheet Binomial Pricer.xlsx, available in the Additional
Material folder on the course website. Assume that the underlying asset’s spot price is $1, its
volatility is σ = 24%, the riskless rate is 1%, and the period length h = 0.01, so that with
twenty periods T = 0.2 years. (As a check that you have the spreadsheet working properly:
the default derivative that is being priced is an at-the-money call option, and you should be
able to see in cell B73 that with the above parameter values, its price is $0.043.)

(a) What are the initial price and delta of a derivative that pays the square of the underlying
asset’s price at time T ?
(b) What are the initial price and delta of a derivative that pays the square root of the
underlying asset’s price at time T ?
(c) Qualitatively, what can you say about the gamma of the “square security” and the
gamma of the “square root security”? Note that gamma is the sensitivity of the delta of
a derivative with respect to changes in the underlying’s price.