116 9.

WEEK 9

Math 366 Winter 2021 Week 9 Assignment Solution

E XERCISE 9.1. The ∆ of an option f ( T; S) is defined as ∂ f ( T, S)/∂S, the

derivative of its price with respect to the current stock price S. Given that
the ∆ of a call option is
∆ c = N ( d1 )
in the usual notation, show by the put-call parity that the ∆ of the corre-
sponding put option is
∆ p = − N (−d1 ).

S OLUTION . Differentiating the put-call parity

C − P = S − Ke−rT .
with respect to S, we have
∆C − ∆ P = 1.
Hence
∆ P = ∆C − 1 = N (d1 ) − 1 = − N (−d1 ).

E XERCISE 9.2. State the Black-Scholes formula of a call option on a stock

with dividend rate q.

S OLUTION . Suppose that the dividend rate for the stock is q. We have
C ( T; K, S) = Se−qT N (d+ ) − Ke−rT N (d− ),
where
ln(S/K ) + (r − q ± σ2 /2) T
d± = √ .
σ T

E XERCISE 9.3. Calculate the Θ, ∆ and Γ of an European call option from

the Black Scholes formula and verify that they satisfy the Black-Scholes
differential equation.

S OLUTION . The Black-Scholes formula is

C ( T; S, K ) = SN (d1 ) − Ke−rK N (d2 ),
where
ln(S/K ) + (r + σ2 /2) T
d1 = √
σ T
and √
d2 = d1 − σ T.
(1) Calculate ∆. Differentiating with respect to S we have
∂d1 ∂d2
∆ = N (d1 ) + SN 0 (d1 ) − Ke−rT N 0 (d2 ) .
∂S ∂S
 4. WEEK 9 ASSIGNMENT 117

It is clear that
∂d1 ∂d2
= .
∂S ∂S
Also
1 2
N 0 (di ) = √ e−di /2 .
2π
It follows that
2
∂d1 e−d1 /2 h 2 2
i
∆ = N ( d1 ) + · √ S − Ke−rT e(d1 −d2 )/2 .
∂S 2π
We have
S
d21 − d22 = (d1 + d2 )(d1 − d2 ) = 2 ln + 2rT
K
2 2 S rT
e(d1 −d2 )/2 = ·e .
K
Note that this identity implies

(9.1) SN 0 (d1 ) = Ke−rT N 0 (d2 ).

It follows that
∆ = N ( d1 ).
(2) Calculate Γ. We have
2
∂∆ ∂d e−d1 /2 1
Γ= = N 0 ( d1 ) 1 = √ · √ .
∂S ∂S 2π Sσ T
(3) Calculate Θ. We have
∂C ∂d ∂d2
Θ= = SN 0 (d1 ) 1 − Ke−rT N 0 (d2 ) + rKe−rT N (d2 ).
∂T ∂T ∂T
Using the identity (9.1) we see that the first two terms become
 
0 ∂d1 ∂d2 σ
SN (d1 ) − = SN 0 (d1 ) · √ .
∂T ∂T 2 T
√
The last step comes from d1 − d2 = σ T, hence
∂d1 ∂d2 σ
− = √ .
∂T ∂T 2 T
Therefore,
2
e−d1 /2 σS
Θ= √ √ + rKe−rT N (d2 ).
2π 2 T
118 9. WEEK 9

(4) Verify the Black-Scholes equation. We have

" 2
#
(σS)2 (σS)2 e−d1 /2 1
Γ + rS∆ − rC = · √ · √
2 2 2π σS T
h i
−rT
+ rSN (d1 ) − r SN (d1 ) − Ke N (d2 )
2
e−d1 /2 σS
= √ √ + rKe−rT N (d2 )
2π 2 T
= Θ.
Therefore we have
(σS)2
Θ= Γ + rS∆ − rC.
2

E XERCISE 9.4. Differentiate the Black-Scholes formula to verify that

∂C
ρ= = KTe−rT N (d2 )
∂r
and √
∂C S T − d2
κ= = √ e 1.
∂σ 2π
S OLUTION . We have
∂d1 ∂d2
= .
∂r ∂r
Using this equality and (9.1) we have
∂C
ρ=
∂r
∂d1 ∂d2
= SN 0 (d1 ) − Ke−rT N 0 (d2 ) + KTe−rT N (d2 )
∂r ∂r
= KTe−rT N (d2 ).
We also have
∂d1 ∂d2 √
− = T.
∂σ ∂σ
Hence,
∂C
κ=
∂σ
∂d1 ∂d2
= SN 0 (d1 ) − Ke−rT N 0 (d2 )
∂σ ∂σ
2
Se−d1 /2 ∂d1
 
∂d2
= √ −
2π ∂σ ∂σ
√
S T 2
= √ e−d1 /2 .
2π
 4. WEEK 9 ASSIGNMENT 119

E XERCISE 9.5. A cash-or-nothing call is an option with the following

the payoff function M (S) = B if S ≥ K and M(S) = 0 if S < K, where K is
the strike price and B is a given payoff amount. Using the same method as
in the derivation of the Black-Scholes formula to find a similar formula for
the cash-or-nothing call option.
S OLUTION . We have
V = e−rT E∗ f (ST ),
where the payoff function is f ( x ) = B if x ≥ K and f ( x ) = 0 if x < K. It
follows that
V = Be−rT P∗ {ST ≥ K } .
The calculation of P ∗ {ST ≥ K } is the same as the calculation of the second
term in the Black-Scholes formula and we have
P∗ {ST ≥ K } = P∗ {W1 ≥ −d2 } = N (d2 ),
where B1 is a standard normal random variable. Therefore
V = Be−rT N (d2 ).
Here is another solution. We have
∂( x − K )+
−B · = f ( x ),
∂K
the payoff function of the cash-or-nothing call. Hence
∂C
V = −B · .
∂K
It is easy to verify that
∂C
= −e−rT N (d2 ).
∂K
Therefore V = Be−rT N (d2 ).

E XERCISE 9.6. Describe the replicating portfolio for the usual put op-
tion. Recall that a replication portfolio of an option is a combination of the
stock and the bond which behaves exactly the same as the option for all
time up to expiration.
S OLUTION . We have
P(t) = Ke−r(T −t) N (−d2 ) − SN (−d1 ),
where
ln(St /K ) + (r + σ2 /2)( T − t)
d1 = √
σ T−t
and √
d2 = d1 − σ T − t.
The ∆ for the put is ∆ = − N (−d1 ). Therefore the replicating strategy for
the call is
xt = − N (d1 ), yt = Ke−r(T −t) N (−d2 ),
120 9. WEEK 9

that is, long Ke−r(T −t) N (−d2 ) shares of cash and short = N (−d1 ) shares of
the stock.

E XERCISE 9.7. Suppose that the current values of the greeks for an op-
tion are as follows:
Θ = 2.0635, ∆ = −0.725, Γ = 0.325.
If the stock increases by 1.5 in two weeks, what is the increment of the value
of the option price in two weeks?
S OLUTION . Since the option price F (t, S) is a function of time and stock
price, by Taylor’s formula we have
∂F ∂F 1 ∂2 F Γ
∆F ∼ ∆t + ∆S + (∆S)2 = −ΘF ∆t + ∆ F ∆S + F ∆S.
∂t ∂S 2 ∂S 2
Note that Θ = ∂F/∂T = −∂F/∂t. Using the given numerical values we
have
14 0.325
∆F = −2.0635 · − 0.725 · 1.5 + · (1.5)2 = −0.80.
365 2
The option value is decreased by 0.80.