4.

WEEK 4 ASSIGNMENT SOLUTION 45

Math 366 Winter 2021 Week 4 Assignment Solution

E XERCISE 4.1. Suppose that a $45 call which expires in one year is val-
ued at $7, and a $45 put with the same expiration date is valued at $5.
Suppose also that the market interest rate is 8%. If the stock is currently
valued at $40, do the option prices satisfy the put-call parity?
S OLUTION . The put-call parity is c − p = S − Kd. We have K = 45, c =
7, p = 5, S = 40, and d = e−0.08 = 0.92. We have c − p = 2 and
S − Kd = 40 − 45 · 0.92 = −1.4.
Therefore the put-call parity does not hold.

E XERCISE 4.2. If the put-call parity is violated at time t, say

c(t, T, K, St ) − p(t, T, K, St ) > St − e−r(T −t) K,
describe a scenario of an arbitrage opportunity.
S OLUTION . Let α = c − p − s + Kd > 0. Starting from nothing, we
create the following portfolio. We sell a call c, buy a put p, buy a share of
stock s and borrow cash Kd. After these transactions, we have α in cash,
which we can deposit in a bank. At time T, the value of the positions in the
portfolio will be
−(ST − K )+ + (K − ST )+ + ST − K = 0,
and the deposit in the bank becomes α/d. This is a risk-free profit starting
from nothing, which represents the profit from an arbitrage opportunity.

E XERCISE 4.3. We usually assume that the stock does not pay divi-
dends. Suppose that the stock distributes dividends at the rate q. Show
that the put-call parity for this dividend-paying stock takes the following
form:
c(t, T, K, St ) − p(t, T, K, St ) = St e−q(T −t) − Ke−r(T −t) .
S OLUTION . We may assume t = 0 for simplicity. Consider the portfolio
having a long position on a call, a short position on a put, and a short
position on e−qT share of the stock. The value of the portfolio is
P(0) = c − p − e−qT S0 .
At time T, the call is worth (ST − K )+ , the put is worth (K − ST )+ . Since
the stock pays dividend at the rate q, the fractional e−qT share becomes one
share, which is worth ST . Hence the value of the portfolio is
P( T ) = (ST − K )+ − (K − ST )+ − ST = ST − K − ST = −K.
By the principle of no arbitrage, P(0) = Ke−rT , hence
c − p − e−qT S0 ) = −Ke−rT ,
46 4. WEEK 4

which can be rewritten as c − p = S0 e−qT − Ke−rT .

E XERCISE 4.4. If the stock price drops too low, it may be more advanta-
geous to exercise an American put option before expiration. Show that this
is the case if  
St < K 1 − e −r ( T − t ) .

S OLUTION . If the stock price is very low, by exercising the put option
before expiration we almost get the full strike price K. This will grow to
more than K at expiration if the interest rate is high. On the other hand,
a put option cannot be worth more than the strike price. Suppose that we
exercise at time t, the payoff is K − St . Its value at time T will be (K −
St )er(T −t) . If the given inequality holds we will have (K − St )er(T −t) > K.
The payoff of the put option at time T is (K − ST )+ ≤ K. Therefore, no
matter what happens to the stock price, the put option exercised at time t
is worth more than the European put option expiring at time T.

E XERCISE 4.5. If the stock pays dividend, then it may be more advanta-
geous to exercise an American call option before expiration. Show that this
is the case when
K
St > .
1 − e q( T −t)
−
Here q is the dividend rate for the stock.

S OLUTION . If the stock price is very high, we exercise the option to get
almost one share of the stock. This will grow to be more than one share of
the stock, whereas the European call option at any time cannot be worth
more than one share of the stock. Suppose that we exercise at time t, we
will get St − K. This is worth (St − K )/St share of the stock. At the T it the
number of shares becomes
St − K q ( T − t )
·e .
St
If
St − K q ( T − t )
·e > 1,
St
at time T, we end up with more than one share of the stock. The European
call is worth at most one share of the stock. Therefore it is better to exercise
at time t if the above inequality holds.

E XERCISE 4.6. Show that other parameters being equal the price of a
call option is an increasing function of the expiration time. Namely, if t ≤
T1 ≤ T2 , then
c(t, T1 , K; S) ≤ c(t, T2 ; K, S)
for all K and S.
 4. WEEK 4 ASSIGNMENT SOLUTION 47

S OLUTION . At time T1 , we have c( T1 , T1 ; K, S) = (S − K )+ . By the put-

call parity,
c( T1 , T2 ; K, S) = p( T1 , T2 ; K, S) + S − Ke−r(T −t) .
Since the call and put prices are always nonnegative, we have c( T1 , T2 ; K, S) ≥
(S − K )+ . This means that at time T1 the expired call is not better than the
call not expired. By the principle of no arbitrage, the same assertion should
also hold at time t, which means that
c(t, T1 ; K, S) ≤ c(t, T2 ; K, S).

E XERCISE 4.7. Suppose that we use the one-step binomial tree to model
the financial market.
(1) State the call and put option price formulas in the one-step binomial
tree model.
(2) Using the one-step binomial tree model to calculate the price of the
following put option:
T = 1, r = 5%, S0 = $10, S1 = $5 or $15, K = $12.

S OLUTION . (1) The call price formula is given by

1 R−d u−R
 
+ +
C= · ( S0 u − K ) + · ( S0 d − K ) .
R u−d u−d
The put price is given by
1 R−d u−R
 
P= · ( K − S0 u ) + + · ( K − S0 d ) + .
R u−d u−d
(2) Easy numerical calculations withe the given values and u = 15/10 =
1.5, d = 5/10 = 0.5, and R = 1 + 0.05 = 1.05.
E XERCISE 4.8. This problem concerns replicating portfolios.
(1) What is a replicating portfolio?
(2) What is the replicating portfolio for the put option in part (b) of the
above exercise?

S OLUTION . (1) The replicating portfolio of an option is a portfolio of a

linear combinations of the underlying assets (the bond and the stock) which
behaves exactly the same as the option.
(2) The number of shares x and y of the stock and the bond in the repli-
cating portfolio is given by the formulas
Pu − Pd 1 uPd − dPu
x= , y= .
S0 u − S0 d R u−d
This can be calculated using a calculator with the given values of the pa-
rameters.
48 4. WEEK 4

E XERCISE 4.9. Restate the put-call parity for the one-step binomial tree
model and show that it holds for the model.
S OLUTION . Put-call parity for a single step binomial tree model is
K
C − P = S0 − ,
R
where C and P are the call and put prices, S0 is the initial stock price, K is
the strike price, and 1/R is the discount factor.

E XERCISE 4.10. Explain why in the binomial tree model we usually re-
quire that the growth factor R = 1 + r, where r is the interest rate, satisfy
the inequalities d < R < u.
S OLUTION . If R < d < u, then the bond returns always less than the
stock. People will not invest in the bond and it would not exist. Likewise,
if d < u < R, the bond returns always more than the stock. People will not
invest in the stock, and the stock would not exist.