ECOM044: Advanced Asset Pricing and Modelling

Queen Mary University of London 2013/2014 COURSEWORK: ASSIGNMENT 1

Attempt all questions. The deadline and the form of submission will be soon announced via QMplus. 1. (Forward price and price of the forward contract). (a) Consider a forward contract maturing at time T written on a stock which will pay a single discrete dividend amount D at time tD where 0 tD T . Denote the time t = 0 price of the stock as S0 and the continuously-compounded risk-free interest rate to the dividend date as rD , and to the maturity of the contract as rT . Use no-arbitrage arguments and construct a trading strategy to determine the time t = 0 forward price F0 . (b) A stock currently trades at 52. The 6-month risk-free interest rate is 1.70% p.a. and the 1-year rate is 2.00% p.a., both with continuous compounding. Calculate the 1-year forward price of the stock, and the price of a 6-month forward contract written on the stock struck at 50, in each of the following scenarios: (i) The stock will pay a cash dividend of 1.50 in 9 months and the 9-month risk-free interest rate is 1.80% p.a. with continuous compounding, (ii) The stock is assumed to have a dividend yield of 5% p.a. with continuous compounding. Hint: For part (a) you need to consider cashows at times t = 0, t = tD and t = T . (25 marks) 2. (European call option prices). Suppose that c1 , c2 and c3 are the prices of European call options with strike prices K1 , K2 and K3 , respectively, where K1 < K2 < K3 and K3 K2 = K2 K1 . All options have the same maturity and are written on the same underlying. (i) Find an inequality relating the call prices, c1 , c2 and c3 . (ii) What is the corresponding result in the case of European put options? 1

Hint: For part (a) consider a portfolio that is long one option with strike price K1 , long one option with strike price K3 , and short two options with strike price K2 . (25 marks) 3. (European and American straddle). A non-dividend-paying stock currently trades at 25 and an investor wishes to buy an at-the-money straddle to try to benet from what he anticipates to be a period of high volatility over the next 3 months. Suppose that the volatility of the stock is 40% and that the risk-free interest rate is 6% p.a. with continuous compounding. Using a 3-step binomial model, (a) Derive the price the investor needs to pay to buy the straddle, assuming options are European, (b) Determine the early exercise premium in the case that the options are American. (25 marks) 4. (Barrier option). A knock-out barrier option (call or put) is an exotic pathdependent option, which may only be exercised at maturity if the price of the underlying never hits a pre-agreed barrier price H throughout the life of the option. Symmetrically, a knock-in barrier option may only be exercised at maturity if the price of the underlying hits the barrier price H . Consider call options with strike 100 and 3-month maturity when the underlying spot price is 95. (a) Should the price of barrier options be more, less or equally as expensive as plain vanilla options with the same characteristics? Justify your answer. (b) Suppose the price of a plain vanilla call with these characteristics is currently 2. (i) What is the value of a knock-out call with barrier H = 97? (ii) What is the value of a knock-in call with barrier H = 97? (iii) If the value of a knock-out call with barrier H = 90 is 1.90, what is the value of a knock-in call with the same barrier? Justify your answer. (c) Assume that the underlying is a non-dividend paying stock and that the continuouslycompounded risk-free rate of interest is 5%. With a 3-step binomial tree calculate the value of a knock-out call with barrier H = 90, assuming that the price of the stock may increase or decrease by 10 at each step. (25 marks)