Derivatives and Fixed Income

Problem Set 2
Solution

CFIVO1007U
February 22, 2018

Exercise 1
Consider a one-step binomial model with the parameters

S0 u d r T
$20 1.1 0.9 8% 3 months

(a) What is the fair value of a European call with strike price $21 maturing at T ?

(b) What is the fair value of a European put with strike price $21 maturing at T ?

(c) What is the proper discount rate for each of these options? Concretely, at which
rate must the expected payoff of the call be discounted to yield the fair price of the
call? Same question for the put. Consider the three possible physical probabilities
of “up” movements p∗ = 0.500, 0.601, 0.700.

Hint: In (c) we are talking about expectations under the physical probability, not under
the risk-neutral probability.

(d) Compare the discount rates of (c) with the risk-free rate and explain intuitively
the differences.

Solution
All the calculations are in PS2 2018 Ex1.xlsx.

(a) The risk-neutral probability is

er∆t − d
p= ≈ 0.601
u−d

1
 and the fair price of the call is thus

c0 = e−rT Ê [S1 − K]+

 

= e−rT p [S0 u − K]+ + (1 − p) [S0 d − K]+

≈0.59.

(b) The fair price of the put is

p0 = e−rT Ê [K − S1 ]+
 

= e−rT p [K − S0 u]+ + (1 − p) [K − S0 d]+

≈1.17

(c) Calculating the fair value of an option with a NPV approach is perfectly feasible
but requires to know the correct required rate of return on the option. Finding
this required rate of return is a priori difficult. However, as we already know the
fair price of the options, we can solve for the required rate of return.
Concretely, writing kc for the required rate of return on the call, we want

c0 = e−kc T (p∗ · 1 + (1 − p∗ ) · 0) ,

with p∗ being the physical probability of an “up” price movement. Solving for kc
yields  
−1 c0
kc = 3 ln ∗
.
12
p
For the suggested values of p∗ , the corresponding required rates of return are as
follows.
If p∗ = 0.500, then kc = −66%.
∗
If p = 0.601 ≈ p, then kc ≈ 0.08 = r.
If p∗ = 0.700, then kc = 69%.
We can argue in a similar manner for the put. We write kp for the required rate
of return on a put option. Solving

p0 = e−kp T (p∗ 0 + (1 − p∗ ) 3) ,

for kp yields  
−1 p0
kp = ln .
3
12
3 (1 − p∗ )
Looking again at the three suggested values of p∗ yields

If p∗ = 0.500, then kp = 98%.

If p∗ = 0.601 ≈ p, then kp ≈ 0.08 = r.
If p∗ = 0.700, then kp = −106%.

2
(d) When p∗ > p, there is a positive risk premium on the stock. As the call offers
a magnified, positive exposure to the stock, we should expect the required rate
of return on the call to be positive and large, as it is. When p∗ < p, there is a
negative risk premium on the stock, which results in a large and negative required
rate of return on the call. When p∗ = p, there is no risk premium on the stock.
So, there should be no risk premium on the call, and it is natural to obtain kc = r.
The intuition for the put is entirely similar. Concretely, if p∗ > p, the risk-premium
on the stock is positive and, as the put offers a negative exposure to the stock,
the required rate of return on the put kp should be lower than the risk-free rate,
consistently with the numbers above. Adapting the argument shows why p∗ < p
must induce kp > r, and p∗ = p must induce kp = r.

3
 Exercise 2
We are currently at t = 0 and the risk-free rate is r = 1%. We model the dynamics of
an underlying with a binomial tree. The tree has monthly time steps and is calibrated
to an annual volatility σ = 15% of the underlying. The resulting tree looks as follows.

∗ S4 = 118.91
p
∗ S3 = 113.87
p
1− ∗
p
∗ S2 = 109.05 ∗ S4 = 109.05
p p
1− ∗
p
∗ S1 = 104.43 ∗ S3 = 104.43
p p
1− ∗ 1− ∗
p p
S0 = 100.00 ∗ S2 = 100.00 ∗ S4 = 100.00
p p
1− ∗ 1− ∗
p p
S1 = 95.76 ∗ S3 = 95.76
p
1− ∗ 1− ∗
p p
S2 = 91.70 ∗ S4 = 91.70
p
1− ∗
p
S3 = 87.82
1− ∗
p
S4 = 84.10

(a) What is the current fair price of an American call on the underlying with strike
price K = 95 and maturity in four months? What is the optimal exercise policy
underpinning this price.

(b) How would you adjust the tree to take into account a unique and anticipated
dividend payment of Q% of the stock price taking place in two months?

Hint 1: What is the ex-dividend price of the underlying right after the dividend payment?

Hint 2: Take a look at Section 21.3, Subsection “Known Dividend Yield” in the textbook.

(c) How are the risk-neutral probabilities on the tree affected by the dividend payment?

Hint: How is the total return (i.e. capital gains + dividends) affected by the dividend
payment?

(d) Can a sufficiently high dividend payment trigger an early exercise of the American
Call? If so, when and starting from which threshold? If not, why not?

Solution
All the calculations are in PS2 2018 Ex2.xlsx.

4
(a) Implementing the formulas presented in Lecture 3 yields a current fair price of
6.83. The corresponding optimal exercise policy is to only exercise the call option
at maturity. Actually, and as we know from the lectures, the early exercise of an
American call is never optimal when there are no dividends.

(b) Assuming that the stock volatility is still the same after the dividend payment, we
can simply multiply the price of the underlying by (1 − Q%) for all the nodes at
the time steps 2, 3, and 4. Actually, as the possible values of the underlying are

5
 calculated recursively in the Excel sheet, we only have to adjust the formulas for
the value of the underlying at the three nodes at time step 2.

(c) The risk-neutral probability at the time steps 0, 2, and 3 is standard and given by

er∆t − d
p=
u−d
with √ 1
u ≡ eσ ∆t
,d≡
.
u
Let us now consider the situation seen from time step 1. The risk-neutral proba-
bility p1 of going up between the time steps 1 and 2 must be chosen to equate the
expected total rate of return on all assets to the risk-free rate. In particular,
  
r∆t 2
S1 e = Ê S2 + dividend payment at t =
12
= p1 (S1 u(1 − Q) + S1 uQ) + (1 − p1 ) (S1 d(1 − Q) + S1 dQ)
= p1 S1 u + (1 − p1 ) S1 d

This equation does not depend on Q and p1 = p. The dividend payment has no
effect on the risk-neutral probabilities on three. The dividend payment has no
effect because it does not affect the total returns on the risky asset.

(d) When the dividend payment reaches approximately 71bps (= 0.71% = 0.0071),
early exercise of the American call becomes optimal for the upper node at the time
step 1. When the dividend payment reaches approximately 7.3% (=0.073), early
exercise becomes optimal for both nodes at the time step 1.
Dividends make it more attractive to actually own a stock as compared to only
owning the option to own the stock in the future. As a result, early exercise of the
call can become optimal, typically just before dividend payments.

6
Exercise 3
An oil company would like to tie its interest payments to its revenues. Concretely, the
company considers issuing an “oil-bond” with principal (or face value) $1000, maturity
one year, and a “coupon” at maturity that is 10 times the difference between the current
price of crude oil and $51 when that difference is positive. If that difference is not positive,
the coupon is zero. Moreover, the coupon is capped at $200.

(a) Write the payoff of the oil-bond as a mathematical function (meaning something
Excel can calculate for you) of the price of crude oil.
(b) The payoff of the oil-bond can be replicated using a risk-free bond, oil, and options
on oil. Describe a replicating portfolio.
(c) Calculate the fair price of the oil-bond in a binomial tree. Assume that storage
costs and convenience yield on oil are both zero. Use the parameters that follow.

oil spot price risk-free rate oil volatility # time steps

$52 1% 40 % 5

Solution
(a) Writing ST for the price of crude oil at maturity, the final payoff of the bond is

− 51]+ ), 200 .

1000
|{z} + |min 10 [ST{z }
principal coupon

(b) We can rewrite the coupon part as

min 10 [ST − 51]+ ), 200 = 10 [ST − 51]+ − [ST − 71]+ .



(1)

A look at the payoff profile of the coupon may make this last equality more intu-
itive:
coupon

200

150

100

50

ST
51 71

7
 The payoff describe by (1) (or the figure) is the payoff of a portfolio of 10 long call
options on oil with strike 51 and 10 short call options on oil with strike 71 (a bull
spread). As a result, a portfolio consisting of

(i) e−r×1 ($1000) ≈ $990.05 invested at the risk free rate

(ii) 10 call options on oil with strike 51
(iii) -10 call options on oil with strike 71

replicates the payoff of the oil bond.

(c) The valuation of the oil-bond is performed in PS3 2018 Ex3.xlsx and yields a fair
price of $1049.79 for the oil-bond.

8
Exercise 4
Check numerically the convergence of the binomial prices toward the Black-Scholes-
Merton prices (see Lecture 3). Concretely, show numerically the convergence for the
three following sets of parameters.
S0 r σ T K
100 2% 20% 3 months 90
100
110
Hint: You can either use the formula for European contract on binomial trees with
multiple periods (Lecture 3) or the function TreeEquityOption provided with the text-
book.

Solution
Functions calculating the fair price of European options both in the binomial and
in the BSM settings are available with the textbook (and on John Hull’s webpage).
These functions are TreeEquityOpt and Black Scholes, respectively. The file DG300
functions.xls (or called similarly) contains a description and typical call for each of
the functions available to DerivaGem’s users.
PS2 2018 Ex4.xlsm calculates the binomial prices of interest for a number of time
steps between 1 and 100:

The plots reported below confirm the convergence of the binomial prices toward the
BSM prices.

9
K = 90

K = 100

K = 110
Exercise 5
Consider a futures price process given at the end of the trading day n by

f0 = 100
r
1
fn+1 = fn + σ Zn
252
iid
for a volatility parameter σ = 10 and iid standard normal random variables (Zn )n≥1 ∼
N (0, 1). The risk-free rate is 0.

(a) Simulate and plot 50 trajectories of the futures price. Pick a horizon T = 1 year
= 252 trading days.

You consider the following trading strategy:

∗ You split the coming year into four periods of 3 months and call them period 1
(first 3 months), period 2 (months 4 to 6), period 3 (months 7 to 9), and period 4
(last 3 months). For simplicity, you call a month a period of 21 trading days.

∗ Your go long 4 future contacts during period 1.

∗ If you made a gain on your futures position during period 1, you exit your futures
position and wait until the end of the year. If you made a loss during period 1,
you double the exposure of period 1 (reaching 8 futures contracts) for period 2.

∗ If you made a gain on your futures position during period 2, you exit your futures
position and wait until the end of the year. If you made a loss during period 2,
you double the exposure of period 2 for period 3.

∗ If you made a gain on your futures position during period 3, you exit your futures
position and wait until the end of the year. If you made a loss during period 3,
you double the exposure of period 3 for period 4.

Let us try to evaluate this trading strategy.

(b) Simulate many possible outcomes of this trading strategy (e.g. 10,000 outcomes).

(c) Based on your simulations, estimate the expected value and the variance of the
gains generated by your strategy at the end of the year.

(d) If you are a risk-averse investor balancing expected return and variance of returns,
is the strategy attractive?

(e) Plot a histogram of the gains generated by your strategy at the end of the year.

(f) Considering the histogram constructed in (e), explain under which circumstances
a trader may rationally decide to implement the strategy.
Solution
(a) The sheet trajectories of PS2 2018 Ex5.xlsx simulates 50 trajectories of the
futures price. Note that simulating a trajectory of the futures price is identical to
simulating a trajectory of a Wiener process, up to the starting value (100 instead
of 0) and the scaling of the increments by the factor σ.

(b) The wealth at the end of the year generated by the trading strategy is
4
X
w1 = (holdings in period i) (change in futures price in period i)
i=1

Let us first focus on the changes in the futures prices. We write Ui for the change
in futures price in period i. Given the assumptions regarding fn ,
3×21 3×21 r
X X 1
U1 = (fk − fk−1 ) = σ Zk .
252
k=1 k=1

Being the sum of independent normal random variables, U1 is normal as well and
its moments are given by
"3×21 r # 3×21 r
X 1 X 1
E [U1 ] = E σ Zk = σ E [Zk ] = 0
252 252
k=1 k=1

and
"3×21 r # 3×21
X 1 X 1 63 σ2
Var [U1 ] = Var σ Zk = σ2 Var [Zk ] = σ 2 = .
252 252 252 4
k=1 k=1
  2

As a result, U1 ∼ N 0, σ4 . Similar arguments shows that

σ2
 
iid
U1 , . . . , U4 ∼ N 0, . (2)
4

We can now turn to the definition of the holdings. We write hi for the holdings in
period i and, in mathematical terms, we can write the strategy as

h1 = 4,

8 if U1 < 0
h2 =
0 otherwise
(3)

16 if U1 < 0 and U2 < 0
h3 =
0 otherwise

32 if U1 < 0 and U2 < 0 and U3 < 0
h4 =
0 otherwise

We can thus rewrite the final wealth as

4
X
w1 = hi Ui . (4)
i=1

The sheet trading implements the formulas (2), (3), and (4) and simulates 10,000
outcomes of the final wealth w1 .

(c) The 10,000 simulations of (b) yield statistics similar to this:

Quantity E [w1 ] Var [w1 ] st.dev. [w1 ] P [w1 > 0]

Estimate -0.92 6014.55 77.55 77%

(d) The expected final wealth generated by the trading strategy is close to zero (the-
oretical arguments could show equality to zero) but the corresponding variance
is strictly positive. The trading strategy looks very much like a pure bet and is
unattractive to a risk-averse investor.

(e) Sheet histogram contains a histogram based on the 10,000 simulations. A his-
togram is reported below. The legend of a bar is the upper bound of the corre-
sponding bin. For example, the final wealth is between 0 and 50 in about 69% of
the simulations.
(f) The final wealth generated by this strategy is very skewed: There are many small
gains and fewer but bigger losses. This should be clear from the histogram. This
can also be seen in the very high probability of having a gain at the end of the
year (around 77%) even though the average is close to zero.
A trader who does not care about the losses she may cause to his employer may
thus find this type of strategy attractive. The trader can take credit for the small
gains and will walk away in case of a large loss. A number of “rogue traders”
appear to have actually implemented this sort of “doubling strategy”.
Exercise 6 (Business Snapshot 15.1)
The returns reported by a mutual fund manager over the last five years (using annual
compounding) are

15%, 20%, 30%, -20%, 25% .

(a) What is the average return of the fund over the last five years?

(b) What is the cumulated return of the fund over the last five years?

(c) What is the cumulated return of a 5 years investment that yields the average return
of the first point every year?

(d) Are your answers to the second and third point the same? Explain why.

Solution
(a) The average return is
1
(0.15 + · · · + 0.25) = 14%.
5
(b) The cumulated return is

(1 + 0.15) . . . (1 + 0.25) − 1 = 79.4%.

(c) An investment yielding 14% per year turns $1 into $ (1 + 0.14)5 = $1.9254 after 5
years. The cumulated return over the five years is thus 92.54%.

(d) The cumulated return of the fund is lower than the cumulated average return of
the fund. Actually, the cumulated return of the fund is equal to the cumulated
geometric average of the yearly returns:

1.794 = (1 + 15%) . . . (1 + 25%)

1 5
 
= ((1 + 15%) . . . (1 + 25%)) 5
= (1 + 12.40%)5

The geometric average 12.40% is thus more informative than the arithmetic average
14% about the fund’s performance. However, a geometric average is always lower
than its arithmetic counterpart and, as a result, rarely reported.