MÄLARDALEN UNIVERSITY EXAMINATION

School of Education, Culture and Communication MAA 303 Introduction to Financial Mathematics
Division of Applied Mathematics Date: June 03, 2022 Time: 3 hours
Instructor: Ying Ni (Tel: 021101385) Aids: Calculator, pen, ruler and eraser

Numer of exercies: 6; maximum points 30 . The marks G,VG require a minimum of 15 and 23 points respectively. Solutions should
be complete, concise, well-motivated, well-organized and legible. Notations that are not used in the textbook must be explained.
All sheets of solutions must be sorted in the order of their page numbers. Good Luck!

1. (5p) A 3-month European put option on a non-dividend-paying-stock is currently selling for

$3.20. The stock price is $45, the strike price is $50, and the risk-free interest rate is 5% per
annum with continuous compounding. Are there any arbitrage opportunities? If yes
construct an arbitrage strategy using a table of cashflows over the time, calculate the
arbitrage profit.

2. (5p) (Two-step tree) A stock price is currently $10. Over each of the next two 3-month
periods it is expected to go up by 10% or down by 10%. The risk-free interest rate is 5% per
annum with continuous compounding. Consider a 6-month American put option with a
strike price of $11. Determine the value of this American put option. (Note: You need to
determine, at each node prior to the maturity, (i) whether an early exercising decision is
optimal (ii) value of the option. )

3. (5p) What are the Black-Scholes prices for a European put option and a European call
option on the following non-dividend-paying stock? The stock price is $10, the strike price
is $10, the risk-free interest rate is 5% per annum with continuous compounding, the
volatility is 20% per annum, and the time to maturity is one year? Round your d1, d2 to four
decimal places (you may round them to two decimal places but you will lose one point for
that).

4. (5p) (One-step tree) A non-dividend-paying stock price is currently $30. It is known that at
the end of 3 months it will either go up by 10% or down by 10%. The risk-free interest rate
is 5% per annum with continuous compounding. Suppose that 𝑆𝑇 is the stock price at the
end of 3 months. What is the value of a European-style derivative with following payoff
function: [max(𝑆𝑇 − 30, 0)]2 ? Use no-arbitrage arguments via constructing riskless
portfolio, you need to compute the “Δ” of this derivative.

5. (5p) A long forward contract on a dividend-paying stock was entered some time ago. It
currently has 6 months to maturity. The stock price and the delivery price is $50 and $50
respectively. The risk-free interest rate with continuous compounding is 5% per annum for
all maturities. The underlying stock is expected to pay only one dividend of $2 per share in
2 months.
a. (2 p) What is value of this forward contract?
b. (3 p) Three months later, the price of the stock is $52 and the risk-free rate of interest is
6% per annum with continuous compounding. What are the forward price and the value
of this forward contract?

6. (5p) Simple Exercises (You may simply write down the answer, without giving any
explanations/motivations /steps.)
a) (1p) Write down the payoff function of a short put option.
b) (2p) Construct a portfolio of European options that can replicate (the payoff of) a
long position in a forward contract with delivery price K and maturity T.
c) (2p) The zero rate for an 1-year investment is 5% per annum, the zero rate for an 2-
year investment is 6% per annum. What is the forward rate between the end of year
one and the end of year two. All rates are continuous compounding rates.

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Formulas

(1) A European call option on a non-dividend-paying stock must be worth more than
𝑚𝑎𝑥(𝑆0 − 𝐾𝑒 −𝑟𝑇 , 0)

(2) A European put option on a non-dividend-paying stock must be worth more than
𝑚𝑎𝑥(𝐾𝑒 −𝑟𝑇 − 𝑆0 , 0)

𝑅 𝑚
(3) 𝑒 𝑅𝑐 = (1 + 𝑚𝑚) , Rc: rate of interest with continuous compounding, Rm: equivalent rate with
compounding m times per annum.

(4) Summary of results for a contract with time to maturity T on an investment asset with price S0
when the continuously compounded risk-free interest rate for a T-year period is r.

Asset Forward/Future Price Value of long forward contract

with delivery price K

Provides no income 𝑆0 𝑒 𝑟𝑇 𝑆0 − 𝐾𝑒 −𝑟𝑇 or (𝐹0 − 𝐾)𝑒 −𝑟𝑇

Provides known income

with present value I: (𝑆0 −𝐼)𝑒 𝑟𝑇 𝑆0 −𝐼 − 𝐾𝑒 −𝑟𝑇

Provides known yield q: 𝑆0 𝑒 (𝑟−𝑞)𝑇 𝑆0 𝑒 −𝑞𝑇 −𝐾𝑒 −𝑟𝑇

(5) Value of a short forward contract with delivery price K: derive it using (4).

(6) Risk-neutral valuation formula for two-step tree (for European options)
𝑒 𝑟∆𝑡 − 𝑑
𝑓 = 𝑒 −2𝑟∆𝑡 [𝑝2 𝑓𝑢𝑢 + 2𝑝(1 − 𝑝)𝑓𝑢𝑑 + (1 − 𝑝)2 𝑓𝑑𝑑 ], 𝑝=
𝑢−𝑑
(7) put-call parity 𝑐 + 𝐾𝑒 −𝑟𝑇 = 𝑝 + 𝑆0

(8) Black-Scholes option pricing formula (for European call option on a non-dividend-paying stock)

𝑐 = 𝑆0 𝑁(𝑑1 ) − 𝐾𝑒 −𝑟𝑇 𝑁(𝑑2 ),

where
𝑆 𝜎2
ln ( 𝐾0 ) + (𝑟 + 2 ) 𝑇
𝑑1 = , 𝑑2 = 𝑑1 − 𝜎√𝑇.
𝜎√𝑇

Value of 𝑁(𝑥): see attached tables.

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