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Hw2 Suggested Solution

This document provides solutions to questions from a homework assignment on portfolio analysis and option pricing. Question 1 examines an arbitrage opportunity between two portfolios, one holding stock and the other holding a call option plus cash. An arbitrageur can realize risk-free profit by going long one portfolio and short the other. Question 2 values European and American put options using the binomial model and finds the strike price where immediate exercise is optimal. Question 3 applies put-call parity to identify an arbitrage strategy involving a put option, call option, stock, and cash. The remaining questions provide solutions to simulation methods, expectation and variance calculations, and Black-Scholes option pricing with time-varying

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207 views4 pages

Hw2 Suggested Solution

This document provides solutions to questions from a homework assignment on portfolio analysis and option pricing. Question 1 examines an arbitrage opportunity between two portfolios, one holding stock and the other holding a call option plus cash. An arbitrageur can realize risk-free profit by going long one portfolio and short the other. Question 2 values European and American put options using the binomial model and finds the strike price where immediate exercise is optimal. Question 3 applies put-call parity to identify an arbitrage strategy involving a put option, call option, stock, and cash. The remaining questions provide solutions to simulation methods, expectation and variance calculations, and Black-Scholes option pricing with time-varying

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andrewsource1
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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RMSC4001 HW2 suggested solution

Question 1
Portfolio A: Holding a unit of stock (S0 =64)
Portfolio B: Holding 1 call option (c0 =5) and having 60e0.124/12 + 0.8e0.12/12 in money account
At the end of the first month
Portfolio A: Holding a unit of stock and 0.8 in money account
Portfolio B: Holding 1 call option and having 60e0.123/12 + 0.8 in money account
At maturity,
AT = ST + 0.8e0.123/12
BT = max(ST 60, 0) + 60 + 0.8e0.123/12 = max(ST , 60) + 0.8e0.123/12 > AT
4
. However,
Value of Portfolio A should be less than or equal to that of Portfolio B at t 12
value of Portfolio A at time 0 is 64 and value of Portfolio B at time 0 is 63.44. So arbitrage
opportunity exists. Arbitrageur can long Portfolio B and short Portfolio A to realize a risk-free
profit of 0.56 at time 0. Of course, one can get another profit of K ST at maturity if ST < K.

Question 2

u = e0.2

0.25

= 1.105171 d = 1/u = 0.904837

(a) European put option price is $2.0928.


(b) American put option price is $2.5420.
(c) You can use "Solver" to search the value or bisection method to find the minimum of K
such that K S0 = f0 . The strike price should be something around $43.297385 such that it is
optimal to be exercised immediately.
Question 3
By put-call parity with dividend, the fair price of put option is
p = c + Ker(T t) + D S = 2 + 30e0.1/2 + 0.5e0.12/12 + 0.5e0.15/12 29 = 2.508213
Now the put option worth $3, one can make arbitrage by
Short one European put option and short sell one unit of asset to get $32
Long one European call option and 30e0.1/2 + 0.5e0.12/12 + 0.5e0.15/12 in money account
The strategy provides a cash inflow $0.4918 at time 0. At maturity, both portfolios worth the
same.
Question 4
(
f (x) =

x5
50
x+25
150

5 x 10
10 < x 25

(
F (x) =

(x5)2
100
2
1 (25x)
300

5 x 10
10 < x 25

(a)
1. Generate U U nif (0, 1).
p
2. If U 0.25, then set X = 2 + 100U . If U > 0.25 , then set X = 25 300(1 U )
(b) ex , x > 0
f (x)
=
g(x)
Set =

1
15

such that

f (x)
g(x)

x5 x
e
5
50
(25x) x
e
150

x 10
10 < x 25

is increasing at 5 x 10 and decreasing at 10 < x 25.

c=

(10 5)(15) 10/15 3 2/3


e
= e
50
2

Algorithm:
1. Generate U1 U nif (0, 1)
2. Set Y = 15ln(1 U1 ).
3. Generate U2 U nif (0, 1).
f (Y )
4. If U2 cg(Y
, then set X = Y , otherwise return step 1.
)
(
Y 5 2/3 Y /15
e
e
5 Y 10
f (Y )
5
= 25Y
cg(Y )
e2/3 eY /15 10 < Y 25
15
(c) h(x) =

1
20

5 x 25
f (x)
=
h(x)

f (x)
h(x)

2
(x 5) 5
5
2
(25 x)
15

x 10
10 < x 25

is increasing at 5 x 10 and decreasing at 10 < x 25.


2
c = (10 5) = 2
5

Algorithm:
1. Generate U1 U nif (0, 1).
2. Set Y = 5 + 20U1 .
3. Generate U2 U nif (0, 1).
f (Y )
4. If U2 ch(Y
, then set X = Y , otherwise return step 1.
)
(
1
(Y 5) 5 Y 10
f (Y )
= 51
ch(Y )
(25 Y ) 10 < Y 25
15

Question 5
(a) Suggested simulation algorithm (one-shoot)
1. Generate Zi N (0, 1).

(i)
2. Set ST = S0 exp[(r 0.5 2 )T + T Zi ]
(i)
3. Pi = max(ST er(1T ) K, 0)
4. Repeat step 1 to 3 10000 times.
5. Call price =erT P .
(b) Total number of random variables needed=10000 standard normal.
(c) We can repeat the above algorithm for 100 times (or even more) to compute 100
option prices. Then we can obtain the sample mean x and sample standard deviation s.
And see whether the S.D is large.
(d) One way to improve the accuracy is by increasing the number of sample paths.
Question 6
(a)
1

Z

t dWt = 0

E(X) = E
0

t4 dt =

V ar(X) =
0

1
5

(b)
1

Z


tWt dWt = 0

E(X) = E
0

V ar(X) =

t3 dt =

E(tWt ) dt =
0

1
4

(c)
h W1 i
1
1
1
E(X) = E e 2 = e 2 (1) 4 = e 8
 W 1   1 2
1
1
V ar(X) = E e
e8 = e2 e4
(d)
Z

Z
Wt dt = W1

X=

0
1

Z


(1 t)dWt

E(X) = E

(1 t)dWt

tdWt =

=0

Z
V ar(X) =

(1 t)2 dt =

1
3

Question 8
(a)

1
2
dlnSt = r(t) (t) dt + (t)dWt
2

Z T
Z T
1 0.04t
1 0.02t
lnST = lnS0 +
0.1(1 + sint) + 0.03t e
dt +
e
dWt
8
0
0 2
1
1
3 2 25 0.04T 121
E(lnST ) = ln100 + T cosT +
T + e

10
10
200
8
40
25
0.04T
)
V ar(lnST ) = (1 e
4
lnST N (E(lnST ), V ar(lnST ))


(b)
RT

CE (t) = St (d1 ) Ke t r( )d (d2 )



RT 
+ t r( ) + 21 ( )2 d
ln 100
K
qR
d1 =
T
( )2 d
t
s
Z T
( )2 d
d2 = d1
t

(c)
CE (0) 12.27

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