BSc Econometrics and Operations Research

FEB23006 Quantitative Methods for Finance

Solutions to Exercises “Derivatives: Pricing and Hedging”

EXERCISE 1 [Option basics]

Q1.1) Let ST denote the stock price at maturity of the call option. Buying 100
shares in the spot market requires an investment of 3,600 USD. In case ST = 45,
the value of the 100 shares increases to 4,500 USD, giving a profit of 900 USD or
25% (=900/3,600). Buying 100 call options requires an investment of only 360 USD.
The options’ value at maturity is equal to 100 × max(ST − K, 0) USD, where K is
the strike price. With K = 36 and ST = 45, the options are worth 900 USD. This
corresponds with a profit of 540 USD, or 150% (=540/360). Hence, while the profit
in terms of USD is larger for the investment in stocks, it is much larger in percent
for the investment in options.

Q1.2) Let ST denote the stock price at maturity of the call option. The profit from
buying 100 shares then is equal to 100ST − 3, 600 USD. The profit from buying 1,000
call options is 1, 000 × max(ST − K, 0) − 3, 600 USD, where K = 36 USD is the strike
price. Assuming that ST > K such that the options expire in-the-money, this is
equal to 1, 000ST − 39, 600 USD. This is equal to the profit from buying 100 shares
when ST = 40.

Q1.3) The initial investment is equal to 2×3 USD +4 USD=10 USD. The payoff on
the position in the call and put options is equal to 2×max(ST −30, 0)+max(30−ST , 0)
USD, where ST denotes the stock price at maturity of the options.

(i) When ST > 30 USD, the put option expires worthless, while the payoff from
the call options is 2(ST − 30) USD. This is equal to the initial investment of 10
USD when ST = 35 USD. For higher values of ST , the investor makes a profit.

(ii) When ST < 30 USD, the call options expire worthless, while the payoff from
the put option is (30 − ST ) USD. This is equal to the initial investment of 10
USD when ST = 20 USD. For lower values of ST , the investor makes a profit.

1
EXERCISE 2 [Arbitrage opportunities]

Q2.1) If p > K, the put option is too expensive so we should short it.
At time 0:

• Write/Short the put; CF= +p

• Invest K in a riskfree bond; CF= −K [we could also invest Ke−rT ]

• Net CF: p − K > 0 (as p > K) [or p − Ke−rT > 0 (as p > K > Ke−rT when
r > 0)]

At the time of maturity T

− If ST > K

• The put option expires out-of-the-money and will thus not be exercised;
CF=0
• The value of the bond investment is KerT ; CF= KerT [or K in case we
had invested Ke−rT at time 0]
• Net CF: KerT [or K]

− If ST ≤ K

• The put option expires in-the-money and will thus be exercised, so we

need to buy the stock for K; CF= −K
• The value of the bond investment is KerT ; CF= KerT [or K in case we
had invested Ke−rT at time 0]
• Net CF: −K + KerT > 0 when r > 0 [or −K + K = 0] (and in both cases
we still own the stock, which has non-negative value)

Hence, both now (time 0) and at maturity (time T ) there always are non-negative
cashflows, so indeed this is an arbitrage opportunity.

2
EXERCISE 3 [Option strategies]

Q3.1) A long position in a strangle involves buying both a put option and a call
option on the same underlying asset with the same maturity, but where the strike
price of the put option is lower than the strike price of the call option. The solid
lines in the two graphs below show the profit function of two strangles: with strike
prices of 60 and 120 on the left and with strike prices of 80 and 100 on the right,
where the dashed lines show the profits from the positions in the individual put and
call options.
60 60

40 40

20 20
Profits

0 Profits 0

-20 -20

-40 -40
25 50 75 100 125 150 175 200 25 50 75 100 125 150 175 200
Spot price at maturity Spot price at maturity

Combining a long position in the strangle with strike prices of 60 and 120 with
a short position in the strangle with strike prices of 80 and 100 gives the profit
function shown in the graph below, where the dashed lines show the profits from
the positions in the individual strangles. This corresponds with the profit function
of an ‘iron condor’ as shown in the exercise question.
60

40

20
Profits

-20

-40
25 50 75 100 125 150 175 200
Spot price at maturity

3
EXERCISE 4 [Option pricing with binomial trees]

Q4.1) First, the pay-off function of the European put option at the “leaves” of the
tree, that is, at the maturity date of the option is given by max(K − ST , 0), where
ST is the price of the underlying stock at the time of maturity T and K is the ‘strike
price’. In this case, given that K = 90, we find that the pay-off is 0 when ST = 160
or ST = 120, 10 when ST = 80, and 50 when ST = 40.

Next, we work backwards through the tree using risk-neutral valuation to determine
the option value f at a given node ‘now’ based on the values of the option and the
underlying stock price at the subsequent two nodes ‘up’ and ‘down’. We use the
expression of the discounted risk-neutral expectation

f (now) = pf (up) + (1 − p)f (down),

where f (up) and f (down) are the option values when the stock prices moves up and
down, respectively, and where we have used the fact that r = 0. The risk-neutral
probability of the stock moving up is given by (again using that r = 0)

Snow − Sdown
p= .
Sup − Sdown

In this particular case, p has the same value at all nodes, given that we always have
Snow − Sdown = 20 and Sup − Sdown = 40, such that p = 0.5. The value of the option
then follows straightforwardly. For example, in the node where S = 60, the value of
the option is equal to f (now) = 0.5 × 10 + 0.5 × 50 = 30. Applying this methodology
gives option values as shown in the tree below. The price of the put option at the
root of the tree is equal to 10.

Option
160 0
0
140 p=0.5
2.5
p=0.5 120 0
120 5
10
100 p=0.5 100 p=0.5
17.5
80 p=0.5 80 10
30
60 p=0.5

40 50

4
We consider the replicating portfolio consisting of φ units of the underlying stock
and ψ units of the riskless bond. In the current set-up, with r = 0, these are given
by

f (up) − f (down)
φ(now) = , and
Sup − Sdown
ψ(now) = f (up) − φSup .

For example, for the node where S = 100, we have that φ = (0 − 10)/(120 − 80) =
−0.25, and ψ = 0 − (−0.25) × 120 = 30. The values of φ and ψ in all nodes are
shown in the tree below.
The patterns observed in the values of φ and ψ can be understood by considering
the properties of a put option. Consider for example the three nodes at the time
just before maturity of the option. First, in case the underlying stock price S = 140,
the put option is certain to expire out-of-the-money, with payoff equal to 0 both in
case the stock price increases to 160 and in case the stock price declines to 120. The
current value of the put option therefore is 0 and the replicating portfolio is ‘empty’,
that is φ = 0 and ψ = 0.
Second, in case the underlying stock price S = 60, we have φ = −1 and ψ = 90.
This also makes sense, given that at this node it is certain that the option will expire
‘in-the-money’, independent of whether the stock price increases to 80 or declines
to 40 at the maturity date. Thus, the value of the option will move 1-to-1 with the
stock price (but in the opposite direction, given that it concerns a put option), such
that its delta (which is equal to φ) is −1. The number of riskless bonds ψ that is
required for replication is equal to the strike price K = 90.
Third and finally, in case the underlying stock price S = 100, the delta of the
option (and thus φ) is equal to −0.25. This can be understood by noting that the
option’s value increases if the stock price decreases to 80, while the option expires
worthless if the stock price increases to 120.

Option
φ=0 160 0
ψ=0
φ = -0.125 140
ψ = 17.5
φ = -0.375 φ = -0.25 0
120 120
ψ = 47.5 ψ = 30
φ = -0.625 100
100 ψ = 67.5
80 φ = -1 80 10
ψ = 90
60
40 50

5
EXERCISE 5 [Option pricing with binomial trees]

Q5.1) First, we use the pay-off function of the European ‘down-and-out’ put option
at the “leaves” of the tree, that is, at the maturity date of the option. If ST < K the
pay-off of the option is equal to K − ST as long as St > B at all points t = 0, . . . , T ,
where K is the ‘strike price’ and B is the barrier. Otherwise, the pay-off is equal
to zero. This means that at leaves that can be reached via different paths, multiple
payoffs are possible, depending on whether or not the stock price fell below the
barrier at some point along the path. In this case, given that K = 80 and B = 46,
this occurs for the leaves with ST = 48.6 and ST = 64.8. On the one hand, if these
are reached via the node where S∆t = 45 < B, the pay-off of the option is 0. On the
other hand, if these leaves are not reached via this node, the pay-off of the option
is 31.4 in case ST = 48.6 and 15.2 in case ST = 64.8. For the other two leaves, we
find a unique pay-off equal to 0 both when ST = 36.45 or ST = 86.4.
Having determined the payoff of the ‘down-and-out’ put at maturity we work
backwards through the tree using risk-neutral valuation to determine the option
value f at a given node ‘now’ based on the values of the option and the underlying
stock price at the subsequent two nodes ‘up’ and ‘down’. We use the expression of
the discounted risk-neutral expectations

f (now) = pf (up) + (1 − p)f (down),

where f (up) and f (down) are the option values when the stock prices moves up and
down, respectively, and where we have used the fact that r = 0. The risk-neutral
probability of the stock moving up is given by (again using that r = 0)

Snow − Sdown
p= .
Sup − Sdown

In this case, the probability p does not vary throughout the tree: at each node, it
holds that Sup = 1.2Snow and Sdown = 0.9Snow , such that p = 0.333.
Given that the option’s payoff at the leaves with ST = 48.6 and ST = 64.8
depends on the path traveled by the spot price, we also obtain two possible prices
for the option at the middle node at 2∆t where S2∆t = 54, depending on the value
of S at time ∆t. On the one hand, in case S∆t = 60, we have f (up) = 15.2 and
f (down) = 31.4, such that the value of the option in the node S2∆t = 54 is equal to
f (now) = 0.333 × 15.2 + 0.667 × 31.4 = 26. On the other hand, in case S∆t = 45,
we know the option is going to expire worthless (as S∆t < B) such that the value of
the option in the node S2∆t = 54 is already equal to 0.
Applying this methodology to all nodes in the tree gives results as shown below.
For nodes that have two numbers, the left one is the option value in case the barrier
has not been exceeded and the right one is the option value (namely 0) when the
barrier has been ‘hit’. The price of the option at the root of the tree is equal to 6.90.

6
 Option
86.4 0
10.13
72
20.71
60 26;0 64.8 15.2;0
6.90
50 54
0
45 48.6 31.4;0
0
40.5
36.45 0

Time: 0 Δt 2Δt 3Δt=T

Q5.2) The delta of an option (portfolio) is defined as the sensitivity of the value of
the option (portfolio) to the spot price of the underlying stock. In binomial trees
as considered here, the delta is equal to the number of stocks in the ‘replicating
portfolio’, consisting of φ units of the underlying stock and ψ units of the riskless
bond, where φ and ψ are such that the portfolio value (and payoff) perfectly mimics
the option (portfolio) value (and payoff). In the current set-up, with r = 0, these
are given by
f (up) − f (down)
φ(now) = and ψ(now) = f (up) − φSup .
Sup − Sdown

For example, for the node at ∆t where S∆t = 60, we have that φ = (10.13−26)/(72−
54) = −0.88, and ψ = 10.13 − (−0.88 × 72) = 73.6. The values of φ and ψ for the
bear spread in all nodes are shown in the tree below.
For the interpretation of delta, consider for example the three nodes at the time
just before maturity of the option. First, in case the underlying stock price S2∆t =
40.5, the delta of the put option is equal to 0. This makes sense, given that at this
node it is certain that the put option will expire worthless as the barrier B = 46 has
been exceeded, independent of whether the stock price increases to 48.6 or declines
to 36.45 at the maturity date.
Second, in case the underlying stock price S2∆t = 54, the delta of the put option
is either equal to −1 or equal to 0, depending on whether S∆t = 60 or S∆t = 45. This
can be understood by noting that in the second case the barrier has been exceeded
so it is certain that the put option will have value 0 at maturity. In the first case, it
is certain that the put option (with strike K = 80) will expire ‘in-the-money’, while
it is not possible that the barrier B is going to be exceeded. Hence, its value/payoff
moves 1-to-1 with the price of the underlying implying a delta of −1.
Third, in case the underlying stock price S2∆t = 72, the delta of the put option
is equal to −0.7. This also makes sense: the put option will expire in-the-money
if the stock price declines to 64.8 and out-of-the-money if the stock price increases
to 86.4. Given that the current spot price is below the strike price (such that the

7
option is ‘in-the-money’), it follows that the delta will be negative and larger than
one half in magnitude.
The most striking thing about the delta of the ‘down-and-out’ put option is that
it takes a value of 1.38 at the root of the tree. This is striking, as (i) usually the
delta for a put option is negative, and (ii) even when delta is positive (like for call
options, for example), it typically remains below 1. The ‘down-and-out’ feature of
the put option causes different behavior at the root of the tree: as observed before,
the option value actually increases when the spot price moves up to S∆t = 60 and
falls to zero when S∆t = 45. Hence, at the root of the tree the option actually has
the characteristics of a call - hence a positive delta. Due to the combination of values
of K and B the difference in option values at the two nodes at ∆t is larger than the
difference between the spot prices, causing the delta to be larger than 1.

Option
 = -0.70 86.4 0
 = 60.8
 = -0.88 72
 = 73.6
 = 1.38  = -1;0 15.2;0
60 64.8
 = -62.13  = 80;0
=0 54
50 =0
45 =0 48.6 31.4;0
=0
40.5
36.45 0

Time: 0 Δt 2Δt 3Δt=T

8
EXERCISE 6 [Option pricing with binomial trees]

Q6.1) First, we have to determine the payoff of the option at the time of maturity
T . Note that the floating lookback call option can be interpreted as a ‘regular’ call
option but with a varying strike price K = min0≤t≤T (St ), which is determined by the
path that the spot price of the underlying stock has taken. This means that at leaves
that can be reached via different paths, multiple payoffs are possible. For example,
the leaf where ST = 62.5 can be reached along three paths (from time 0). For two
of those, the minimum spot price along the path is equal to 50, while for the third
path the minimum spot price is equal to 40. Hence, the payoff of the option when
ST = 62.5 is either 12.5 or 22.5. The same holds for the leaf where ST = 40, where
the option’s payoff is equal to either 0 or 8, depending on whether the minimum
spot price along the path leading to this leave is 40 or 32. The ‘extreme’ leaves with
ST = 97.66 and ST = 25.6 can be reached only by a single path; hence the option
has a unique payoff in these leaves, equal to 47.66 and 0, respectively.
Next, we work backwards through the tree using risk-neutral valuation to deter-
mine the option value f at a given node ‘now’ based on the values of the option and
the underlying stock price at the subsequent two nodes ‘up’ and ‘down’. We use the
expression of the discounted risk-neutral expectation

f (now) = pf (up) + (1 − p)f (down),

where f (up) and f (down) are the option values when the stock prices moves up and
down, respectively, and where we have used the fact that r = 0. The risk-neutral
probability of the stock moving up is given by (again using that r = 0)

Snow − Sdown
p= .
Sup − Sdown

In this case, the probability p does not vary throughout the tree: at each node, it
holds that Sup = 1.25Snow and Sdown = 0.8Snow , such that p = 0.444.
Given that the option’s payoff at the leaves with ST = 62.5 and ST = 40 depends
on the path traveled by the spot price, we also obtain two possible prices for the
option at the middle node at 2∆t where S2∆t = 50, depending on the value of S
at time ∆t. On the one hand, in case S∆t = 62.5, we have f (up) = 12.5 and
f (down) = 0, such that the value of the option in the node S2∆t = 50 is equal to
f (now) = 0.444 × 12.5 + 0.556 × 0 = 5.56. On the other hand, in case S∆t = 40, we
have f (up) = 22.5 and f (down) = 0, such that the value of the option in the node
S2∆t = 50 is equal to f (now) = 0.444 × 22.5 + 0.556 × 0 = 10.
Applying this methodology to all nodes in the tree gives results as shown below,
where the top number at each node is the minimum spot price on paths leading to
that node and the bottom number is the corresponding option value. The price of
the option at the root of the tree is equal to 10.49.

9
 50
50 97.66 47.66
28.125

50 78.13
15.59
50 40 50 40
62.5 62.5 12.5 22.5
10.49 5.56 10

50
40 50
6.42
40 32
40 32 40 0 8
3.56

32
25.6
25.6
0
Time: 0 ∆t 2∆t 3∆t=T

Q6.2) The delta of a call option is defined as the sensitivity of the option price to the
spot price of the underlying stock. In binomial trees as considered here, the delta is
equal to the number of stocks in the ‘replicating portfolio’, consisting of φ units of
the underlying stock and ψ units of the riskless bond, where φ and ψ are such that
the portfolio value (and payoff) perfectly mimics the option value (and payoff). In
the current set-up, with r = 0, these are given by
f (up) − f (down)
φ(now) = , and
Sup − Sdown
ψ(now) = f (up) − φSup .
Note that at time 2∆t, we have two possible values for φ and ψ at the node
where S2∆t = 50, given that the value of the option at that node depends on the
path taken by the spot price so far. The values of φ and ψ in all nodes of the tree
are shown below.
As noted before, it holds that the delta of the option is equal to φ. For the
interpretation of delta, we observe that all delta’s are positive, which is expected
given that we are dealing with a call option, for which we know the value is increasing
with the current spot price. Furthermore, for a ‘plain vanilla’ call option, we know
that delta varies between 0 and 1, with delta approaching 0 as the option moves
very deep out-of-the-money (i.e. when the spot price becomes very low relative to
the strike price) and 1 as the option moves very deep in-the-money (i.e. when the
spot price becomes very high relative to the strike price). In the current set-up, with
r = 0, a call option that is certain to expire in-the-money moves 1-to-1 with the
underlying stock price and its delta is equal to 1. This is observed, for example, in
one of the nodes at the time just before maturity where the underlying stock price
S2∆t = 78.13.
A key feature of the ‘floating lookback ’ call option is that it can never (be or)
expire out-of-the-money, given that the strike price is defined as the minimum spot
price observed during the lifetime of the option. Hence, one might perhaps have
expected that the delta would always exceed 0.5. This apparently is not the case,

10
given that we observe some deltas smaller than 0.5, in particular at time 0 and at
time ∆t when S∆t = 40. The reason for this phenomenon is that the spot price
affects the option value in two ways: On the one hand, there is a positive effect
given that the pay-off is equal to the difference between the spot price and the strike
(thus higher spot prices lead to a larger difference (for a given strike price) and thus
a higher option value). On the other hand, there is a negative effect due to the
influence that the spot price has on the strike (higher spot prices lead to a higher
strike and thus a lower option value).
This also can help to understand the deltas at the node where the underlying
stock price is S2∆t = 50. In case this node is reached via S∆t = 40, the spot price has
already taken its minimum value along all possible paths and thus the strike price
is fixed (at the value of 40) and the option is certain to expire in-(or at-)the-money,
giving a delta equal to 1. In case the node S2∆t = 50 is reached via S∆t = 62.5, the
strike price can still change (in case the stock price moves to ST = 40) and thus the
negative effect mentioned above is still present.
50
φ=1 97.66 47.66
ψ = -50

φ = 0.80 78.13
ψ = -34.57
φ = 0.56; 1 62.5
50 40
φ = 0.41 62.5 ψ = -22.22; -40 12.5 22.5
ψ = -9.88
φ = 0.36 50
50 ψ = -7.90
40 32
40 φ = 0.56 40 0 8
ψ = -14.22

32
25.6
25.6
0
Time: 0 Δt 2Δt 3Δt=T

11
EXERCISE 7 [Delta hedging]

Note that the δ of a call or put option always refers to a long position in the option
per unit of the underlying asset. To find the ‘position delta’, we multiply (a) the
number of options that we buy (which thus is a negative number if we sell/write the
option) with (b) the number of units of the underlying and with (c) the given δ.

Q7.1) If we write 1 put option on 100 shares of the underlying stock with a δ = −0.3,
the position delta is equal to −1 × 100 × −0.3 = 30. We must therefore sell 30 shares
of the underlying stock to make the position delta neutral.

Q7.2) The position delta of the short put is equal to −1 × 100 × −0.3 = 30. The
position delta of the long call is equal to +1×100×0.6 = 60. Hence, the net position
delta is equal to 30 + 60 = 90. We must therefore sell 90 shares of the underlying
stock to make the position delta neutral.

12
EXERCISE 8 [Delta-gamma hedging]

Q8.1)

(i) The position gamma of the short call is equal to −1 × 100 × 0.3 = −30. The
other call option has a gamma that is equal to 100 × 0.15 = 15 per option.
Hence, we must buy two of these call options to make the portfolio gamma
neutral, as −30 + 2 × 15 = 0.

(ii) The short position in the call option has a position delta equal to −1 × 100 ×
0.7 = −70. The long position in the other call option has a position delta equal
to 2 × 100 × 0.2 = 40. The net position delta is therefore −70 + 40 = −30.
Hence, we should buy 30 stocks of the underlying to make the portfolio gamma-
delta neutral.

Q8.2)

(i) The position gamma of the long call is equal to 100 × 0.3 = 30. The put option
has a position gamma that is equal to 100 × 0.15 = 15 per option. Hence, we
must sell (write) two put options to make the portfolio gamma neutral, as
30 + (−2) × 15 = 0.

(ii) The long call has a position delta equal to 100 × 0.7 = 70. The written puts
have a position delta equal to −2 × 100 × −0.8 = 160. The net position delta
is therefore 70 + 160 = 230. Hence, we should sell 230 stocks of the underlying
to make the portfolio gamma-delta neutral.

13
EXERCISE 9 [Delta-gamma hedging]

Q9.1) A long position in a single call option gives a delta of 100 × 0.3 = 30, and a
gamma of 100 × 0.025 = 2.5. A long position in a single put option gives a delta of
100 × −0.4 = −40 and a gamma of 100 × 0.05 = 5.

(i) Given that we have a short position in two calls we have a total gamma of
−2 × 2.5 = −5. Hence, given that the put option has a gamma of 5, we must
buy 1 put to make our overall position gamma neutral.

(ii) The short position in two calls and the long position in one put gives a total
delta of (−2 × 30) + (1 × −40) = −100. Hence, we must buy 100 shares of the
underlying to make our overall position delta neutral (given that a share has
a delta of 1).

(iii) If the share price declines from 40 to 39 euros, the value of the portfolio should
not change, given that we have created it in such a way that it is delta neutral.
The value of our long position in the underlying decreases, but this is offset
by a corresponding increase in the value of our position in the call and put
options.
To see that this indeed is the case, note that the value of our long position in the
underlying stock decreases by 100 (from 100 × 40 = 4000 to 100 × 39 = 3900).
At the same time, the value of the short position in the two call options changes
by (39 − 40) × 0.3 × 100 × (−2) = 60, while the value of the long position in
the put option changes by (39 − 40) × 1 × −40 = 40. Taken together, these
changes in the value of our positions in the call and put options exactly offset
the change in the value of our position in the underlying stock.

Similarly, the delta of the portfolio should not change, given that we have
created it in such a way that it is gamma neutral. Due to the decline in the
spot price of the underlying, the delta of the call option will change from 0.3
to 0.3 + (39 − 40) × 0.025 = 0.275. Similarly, the delta of the put option will
change from −0.4 to −0.4 + (39 − 40) × 0.05 = −0.45. The short position in
two calls and the long position in one put therefore still gives a total delta of
(−2 × 0.275 × 100) + (1 × −0.45 × 100) = −100.

The gamma’s of the call and put options will also change. Given that the
strike price of the call option is K = 50, the decline in the spot price of
the underlying means that the call option becomes deeper ‘out-of-the-money’,
hence its gamma will decline. Given that the strike price of the put option is
K = 35, the decline in the spot price of the underlying means that the put
option becomes less ‘out-of-the-money’, hence its gamma will increase. Given
that we have a short position in the call option and a long position in the put
option, this implies that the gamma of our overall portfolio will increase and
becomes positive.

14
(iv) The portfolio consists of a short position in two call options with K = 50, a
long position in a put option with K = 35 and a long position in 100 shares
that have been purchased for a price of S = 40. This gives the profit function
at maturity of the options as shown in the graph below, where the dashed lines
show the profits from the three individual positions in the call and put options
and the underlying stock.

40

20

0
Profits

-20

-40

0 10 20 30 40 50 60 70 80
Spot price at maturity

For spot prices at maturity ST below 35 we make a constant loss of 5, which

results from the fact that the call option expires worthless, while the profit that
we make on the put option offsets the loss on the underlying share (apart from
the strike K = 35 being 5 below the price at which we have bought the shares.
Profits increase to 10 as the spot price increases from 35 to 50 (when both the
call and put expire out-of-the-money). For spot prices above 50, profits decline
again, as we then start losing money on the short position in the call options.
Hence, given the starting point with S = 40, we are effectively betting on an
increase in the underlying share price, but we do not expect the price to exceed
60 at maturity.

15