Recitation 7

Problem 1
A financial firm is offering a synthetic zero-coupon putable convertible bond on the ABC Company.
It works in the following way:

1. The bond has a promised principal payment of $1, 000 three periods from now.

2. At any time after the first period, the holder of the bond can either exchange it for one share
of ABC stock or give it back to the securities firm in return for a payment of $600.

3. The securities firm has set aside four shares of ABC stock to serve as collateral for each
synthetic convertible.

4. The firm can at any time fulfill its entire obligation, and be required to make no other
payments, by giving to the holder of the putable convertible full ownership of the four shares
of stock.

Over each period, the total rate of return on holding ABC stock will be either 100% or −50%. At
the end of each period, the stock will pay one fifth of its pre-dividend value as a cash dividend to
the investor who held the stock during that period.

The remaining 80% of the pre-dividend value will then be the ex-dividend stock price at which
one can purchase stock to hold over the following period or sell stock received from conversion or
default. In other words, over each period the ex-dividend stock price will either increase by 60% or
decrease by 60%.

By reinvesting dividends, an investor owning one share at the beginning of a period will own
1.25 shares at the end of the period. The current ex-dividend stock price is $1, 000, and the interest
rate is 10% per period. The quoted price of the synthetic putable convertible is $1, 000. If the
financial firm fully hedges its position, what will be its realized profit on each bond sold?

Solution: We can use a binomial tree risk-neutral pricing model to solve this problem. The
possible paths for ABC stock over the next three periods are shown in the following diagram:

1
As always, we work backward through the binomial tree.

1. If the stock price on the maturity date is either $4,096 or $1,024, bondholders will choose to
convert the bond to a stock.

2. If the stock price on the maturity date is $256, bondholders will neither convert the bond to
a stock nor exercise the put option, and the financial firm will pay them the principal amount
of $1,000.

3. If the stock price is $64, the financial firm will settle its obligation by giving the bondholders
the four shares of stock held as collateral.

The column to the right of the binomial tree diagram above reports the final payoffs to the bond-
holders at each node.

The value of the putable convertible at the other nodes on the tree can be found by applying
the fundamental valuation equation to obtain the value if the bond is held for one more period.
This value must then be compared with the value generated by immediate conversion or put and
by the immediate forfeiture of the collateral. The final value assigned at each node on the tree
must reflect the optimal use by both parties of the choices available to them.

Specifically, let V (S, n) be the value of the bond when the stock price is S and there are n periods
until maturity. We can solve for the risk-neutral probability of an “up” move, q ∗ , as:

1000 = (2000 × q ∗ + 500 × (1 − q ∗ ))/1.1,

which yields q ∗ = 0.4.

Solving for V (S, n) when n = 1, we have that:

V (2560, 1) = min{4(2560), max[2560, 600, (0.4(4096) + 0.6(1024))/1.1]}

= 2560

V (640, 1) = min{4(640), max[640, 600, (0.4(1024) + 0.6(1000))/1.1]}

= 917.8181
V (160, 1) = min{4(160), max[160, 600, (0.4(1000) + 0.6(256))/1.1]}
= 600

2
Thus, the bond is converted to a stock at the node of the tree where S = 2560, the put is exercised
when S = 160, and the bond is neither converted nor put when S = 640.

Similarly, solving for V (S, n) when n = 2, we have that:

V (1600, 2) = min{4(1600), max[1600, 600, (0.4(2560) + 0.6(917.8181))/1.1]}
= 1600

V (400, 2) = min{4(400), max[400, 600, (0.4(917.8181) + 0.6(600))/1.1]}

= 661.0248

Thus, the bond is converted to a stock at the node of the tree where S = 1600, and the bond is
neither converted nor put when S = 400.

Finally, we can solve for the value of the bond at the initial node of the tree when the stock
price S = 1000:
V (1000) = [0.4(1600) + 0.6(661.0248)]/1.1
= 942.3771
In other words, if the financial firm fully hedges its position, its realized profit on each bond sold
will be 1000 − 942.3771 = $57.6229.

Problem 2
Estimate the value of a new 6-month European-style (arithmetic) average price call option on a
non-dividend-paying stock. The initial stock price is $30, the strike price is $30, the risk-free rate
is 5%, and the stock price volatility is 30%.

(a) Perform the estimation by writing a program to run a Monte Carlo simulation to estimate
the price of the option. Use 5,000 stochastic paths for the risk-neutral representation of the evo-
lution of stock prices assuming lognormality, drawing innovations from a normal distribution, and
with a time step h equal to 1 month.

Solution: Before performing the Monte Carlo simulation, let’s see if we can derive a closed-form
expression for the value of the average price call option. Since this material is more advanced, feel
free to skip to the Monte Carlo simulation if desired.

The option’s payoff depends on the arithmetic average of the price of the underlying stock during
the life of the option. In particular, the payoff is max (0, Savg − K), where Savg is the average price
of the stock.

Under the assumption that Savg is lognormally distributed, the average price call can be valued
using a similar formula to the one we’ve used to price a regular European call. Suppose M1 and
M2 are the first two moments of Savg . The value of the average price call is given by Black’s model:

c = e−rT [F0 N (d1 ) − KN (d2 )]

ln (F0 /K) + σ 2 T /2 √ (1)
d1 = √ ; d2 = d1 − σF T
σF T

3
  
1 M2
with F0 = M1 and σF2 = T ln M12
.

Assuming that the average is calculated continuously, then

e(r−q)T − 1
M1 = S0 ,
(r − q)T
2
!
2e[2(r−q)+σ ]T S02 2S02 1 e(r−q)T
M2 = + − .
(r − q + σ 2 ) (2r − 2q + σ 2 ) T 2 (r − q)T 2 2(r − q) + σ 2 r − q + σ 2

Plugging in r = 5%, q = 0, σ = 30%, T = 0.5, S0 = 30, and K = 30 to the expressions for M1 and
M2
M2 above, we get that M1 = 30.378, M2 = 936.9, and σF2 = T1 ln M 2 = 17.41.
1

Finally, from Equation (1), we can calculate the value of the average price call as:

c = e−0.05×0.5 [30.378N (0.163) − 30N (0.04)] = $1.64.

Using Monte Carlo, we can simulate the lognormal stock price process under the risk-neutral
representation using the following algorithm:
 2
 √
r− σ2 h+σ ht
St+h = St × e
1
where the time step h = 12 and t ∼ i.i.d. N (0, 1).

After generating 5,000 paths for the stock price, we can calculate the payoff on each path i as:

Vi = max avg S1i , . . . , S6i − K, 0 .



Finally, the value of the average price call is given by c = e−0.05×0.5 5000
1 P 1
i Vi . For h = 12 , c = $1.89.
This is close to the analytical result of $1.64 we derived above! See the example R code below.

4
(b) Repeat this exercise but now set the time step h equal to 1 week (treating 6 months as 26 weeks).

Solution: Example R code is provided below. Notice that, with the smaller time step, the simu-
lated value of the average price call of $1.66 is nearly identical to the analytical result of $1.64.

(c) Using the same Monte Carlo simulation of stock prices as in Part (b), what is the price of a
knock-in call option with a strike price of $30 and a barrier of $35?

Solution: The knock-in call option comes into existence when the stock price reaches $35 be-
fore expiration. Using the same algorithm to simulate the lognormal stock price process as in
1
Part (b) with h = 52 , we can simulate the payoff of the knock-in call on a particular path as
max (ST − K, 0) if the stock price reaches $35, and 0 otherwise.

Using the example R code below, the price of the knock-in call is estimated to be $2.65.

5
Problem 3
Explain why a regular European call option is the sum of a down-and-out European call option
and a down-and-in European call option. Is the same true for American call options?

Solution: Recall that a down-and-out call option is a type of knock-out option. Specifically,
it is a regular call option that ceases to exist if the underlying stock price reaches a certain barrier
level H. The barrier level is below the initial stock price.

The corresponding knock-in option is a down-and-in call option. This is a regular call option
that comes into existence only if the stock price reaches the barrier level H.

We have two cases to consider:

1. If the barrier level H is reached, then the down-and-out call option is worth nothing, while
the down-and-in call option has the same value as a regular option.

2. If the barrier level H is not reached, then the down-and-in call option is worth nothing, while
the down-and-out call option has the same value as a regular option.

Thus, the payoffs from a portfolio consisting of a down-and-out call option plus a down-and-in
call option are identical to those of a regular European call option, regardless of whether the
barrier level H is reached. A similar argument cannot be used for American options; generally,
the possibility of early exercise results in different optimal exercise times for down-and-out and
down-and-in American calls.