FINA3203 - H OMEWORK 3

Each sub-question in Questions 1, 2, 3 and 5 gives you five points, if answered correctly. Question 4
gives you 10 points

Question 1:

Shares in XYZ Corporation sell today for $20. The risk-free rate is 3% (continuously compounded). In
the next six months, XYZ shares will either increase in price by 30%, or decrease by 40%. In the following
six months, XYZ shares will again either increase in price by 30%, or decrease in price by 40%. XYZ pays
no dividends.

(1) What is the price of a European call with strike $19 and expiration in one year? Use a binomial tree.
(2) What is the price of a European put with strike $19 and expiration in one year? Use a binomial tree,
and then verify your answer with put-call parity.
(3) Now obtain the prices of these call and put options using risk-neutral probabilities. Verify that you
get the same answers as in (1) and (2).

Question 2:

A share in stock ZZ currently trades at $80. The volatility of the stock price is 25% and the expected
return on this stock is 12%. The continuously compounded risk-free rate is 3%. Assume that the volatility,
the expected rate of return, and the risk-free rate are constant, and that ZZ pays no dividends

(1) Find the prices of an at-the-money European call and an at-the-money European put with maturity
six months for different steps h in the tree (h = T /N). Consider N = 5, N = 10, N = 50, and N = 100
and use the spreadsheet BinomialTree that is on Canvas.
(2) What value of N is needed to get the price from the tree within a cent to the true Black-Scholes-
Merton price?
(3) Find the Black-Scholes Delta’s and Gamma’s of these two options

Question 3:

The spot exchange rate of the Canadian dollar (CAD) is 0.95 USD, with implied volatility of 10%.
The risk-free interest rates in Canada and the United States are 2% and 1% (continuously compounded),
respectively.

(1) Find the price of a one-year European call: right to buy one CAD for 0.98 USD
(2) Find the price of a one-year European put: right to sell one CAD for 0.98 USD

1
This study source was downloaded by 100000883993969 from CourseHero.com on 04-20-2024 01:52:35 GMT -05:00

https://www.coursehero.com/file/75129182/HW-3pdf/
 (3) Find the price of an option to buy 0.98 USD with one CAD in one year

(We have not seen currency options in class. However, they can also be priced using the BSM model.
The only thing you need to do is to treat the interest rate on one of the currencies as a dividend yield. You
have to decide on which currency. Give a one-sentence explanation for your decision.)

Question 4:

The option market does not allow for arbitrage, and the price of stock ZZ is $100. The price of a
European put option written on ZZ with a strike of $100 is $10. The price of a European put with the same
maturity written on ZZ with a strike of $50 is:

(1) lower than $5

(2) equal to $5
(3) higher than $5
(4) we can’t tell
(5) none of the above

Do NOT try to use any involved calculation, and certainly NOT the Black-Scholes formula (note that
we are not given several of its inputs). Just pointing to one of the five given answers, even if correct, will
NOT count. We want to see your logic. You may support this logic with a picture.

Question 5:

I have posted on Canvas a paper titled "The Chinese Warrants Bubble", and you may recognize one
of the authors – Jialin Yu is a professor in the Finance department at HKUST. The paper has a lot of
discussions related to various academic theories, etc., which certainly are beyond what we do in class, so
please IGNORE them. Just go quickly over the paper to get an idea of what it is about. Then answer the
following questions:

(1) What is the paper’s main finding?

(2) On page 2731 they say that in China the stock price is not allowed to drop more than 10% each day,
so today’s price imposes a floor on the possible price at expiration. How would you calculate this
floor?
(3) On page 2729 they say: "We use WuLiang stock’s daily closing price and the previous one-year
rolling daily return volatility to compute the warrant’s Black-Scholes value". Do you see any prob-
lem with that?
(4) The paper makes two warnings (caveats) against relying too much on Black-Scholes. Which are
they?

2
This study source was downloaded by 100000883993969 from CourseHero.com on 04-20-2024 01:52:35 GMT -05:00

https://www.coursehero.com/file/75129182/HW-3pdf/
Powered by TCPDF (www.tcpdf.org)