Buy:

Pay-off = (Exercised price - Strike price) x #options

Cost of options = #options x option price
Net = Pay-off - Cost

Sell:
Pay-off = (Strike price - Exercised price) x #options
Amounts received from options = #options x option price
Net = Amounts received - Pay-off

Theoretical futures price > Actual futures price: sell underlying asset, long futures
Theoretical futures price < Actual futures price: buy underlying asset, short futures
 Chapter 1:

1. A one-year call option on a stock with a strike price of $30 costs $3; a one-year put
option on the stock with a strike price of $30 costs $4. Suppose that a trader buys two call
options and one put option. The breakeven stock price above which the trader makes a
profit is

Stock price > Strike price

→ The put option provides no payoff.
Cost of 2 call options and 1 put option = 2 x 3 + 4 = 10
Payoff from the two call options = (x - 30) * 2 = 10 → x = $35

2. A one-year call option on a stock with a strike price of $30 costs $3; a one-year put
option on the stock with a strike price of $30 costs $4. Suppose that a trader buys two call
options and one put option. The breakeven stock price below which the trader makes a

Stock price < Strike price

→ The call option provides no payoff.
Cost of 2 call options and 1 put option = 2 x 3 + 4 = 10
Payoff from the put option = 30 - x = 10 → x = $20
3. The price of a stock on July 1 is $57. A trader buys 100 call options on the stock with a
strike price of $60 when the option price is $2. The options are exercised when the stock
price is $65. The trader's net profit is

Pay-off from options = (65 - 60) x 100 = $500

Cost of options = 2 x 100 = $200
Net profit = 500 - 200 = $300

4. The price of a stock on February 1 is $124. A trader sells 200 put options on the stock
with a strike price of $120 when the option price is $5. The options are exercised when
the stock price is $110. The trader's net profit or loss is

Payoff that must be made on the options = (120 − 110) x 200 = $2000
Amounts received from options = 5 x 200 = $1000
Net loss = 1000 - 2000 = -$1000

5. The price of a stock on February 1 is $84. A trader buys 200 put options on the stock
with a strike price of $90 when the option price is $10. The options are exercised when
the stock price is $85. The trader's net profit or loss is

Pay-off from options = (90 − 85) x 200 = $1000

Cost of options = 10 x 200 = $2000
Net loss = 1000 - 2000 = -$1000

6. The price of a stock on February 1 is $48. A trader sells 200 put options on the stock
with a strike price of $40 when the option price is $2. The options are exercised when the
stock price is $39. The trader's net profit or loss is

Pay-off that must be made on the options = (40 - 39) x 200 = $200
Amount received from options = 2 x 200 = $400
 Net profit = 400 - 200 = $200

7. A speculator can choose between buying 100 shares of a stock for $40 per share and
buying 1000 European call options on the stock with a strike price of $45 for $4 per
option. For second alternative to give a better outcome at the option maturity, the stock
price must be above

Scenario 1: Buying 100 shares of the stock for $40 per share.
The position in the stock would be worth 100 shares * Stock Price.

Scenario 2: Buying 1000 European call options on the stock with a strike price of $45 for
$4 per option.
The payoff from the options would be 1000 options * (Stock Price - $45).

1000 * Stock Price - 1000 * $45 > 100 * Stock Price

-> Stock Price > $50

8. A trader has a portfolio worth $5 million that mirrors the performance of a stock index.
The stock index is currently 1,250. Futures contract trade on the index with one contract
being on 250 times the index. To remove market risk from the portfolio the trader should

One futures contract protects a portfolio worth 1250×250. The number of contract
required is therefore 5,000,000/(1250 × 250) = 16

→ To remove market risk from the portfolio the trader should sell 16 contracts
 Chapter 2:

1. A company enters into a short futures contract to sell 50,000 units of a commodity for 70
cents per unit. The initial margin is $4,000 and the maintenance margin is $3,000. What
is the futures price per unit above which there will be a margin call?

Initial margin - Maintenance margin = 4,000 - 3,000 = $1,000

Loss per unit = Maximum loss / Number of units
Loss per unit = $1,000 / 50,000
Loss per unit = $0.02

x - 0.02 = 70
→ x = 72 cents

50,000(x - 0.7) = 1,000

→ x = $0.72
2. A company enters into a long futures contract to buy 1,000 units of a commodity for $60
per unit. The initial margin is $6,000 and the maintenance margin is $4,000. What futures
price will allow $2,000 to be withdrawn from the margin account?

Initial margin - Maintenance margin = 6,000 - 4,000 = $2,000

Total value of contract = 1,000 x 60 = $60,000

The contract would have to be worth $62,000 more (60,000 + 2,000 = $62,000) for a
margin call to be made.

Let x = the price required for a margin call to be withdrawn:

1, 000 × (𝑥 − 60) = 2, 000

 𝑥 = $62

3. You sell one December futures contracts when the futures price is $1,010 per unit. Each
contract is on 100 units and the initial margin per contract that you provide is $2,000. The
maintenance margin per contract is $1,500. During the next day the futures price rises to
$1,012 per unit. What is the balance of your margin account at the end of the day?

Changes in futures price = 1,012 - 1,010 = $2 per unit

Sell → Short futures

Since you are in a short position, a rise in the futures price results in a loss. In this case,
the loss would be $2 × 100 = $200.

To calculate the balance of your margin account, we deduct the loss from the initial
margin:

Initial Margin - Loss = Balance of Margin Account

$2,000 - $200 = $1,800

However, we also need to consider the maintenance margin. If the balance of the margin
account falls below the maintenance margin, a margin call is triggered.

The maintenance margin per contract is $1,500. In this case, the balance of your margin
account after deducting the loss is $1,800, which is above the maintenance margin of
$1,500.

Therefore, the balance of your margin account at the end of the day is $3,300 ($1,800 +
$1,500).
4. A hedger takes a long position in a futures contract on a commodity on November 1,
2012, to hedge an exposure on March 1, 2013. The initial futures price is $60. On
December 31, 2012 the futures price is $61. On March 1, 2013 it is $64. The contract is
closed out on March 1, 2013. What gain is recognized in the accounting year January 1 to
December 31, 2013? Each contract is on 1000 units of the commodity.

Hedge accounting is used. The whole of the gain or loss on the futures is therefore
recognized in 2013. None is recognized in 2012. In this case the gain is $4 per unit or
$4,000 in total.

5. A speculator takes a long position in a futures contract on a commodity on November 1,

2012 to hedge an exposure on March 1, 2013. The initial futures price is $60. On
December 31, 2012 the futures price is $61. On March 1, 2013 it is $64. The contract is
closed out on March 1, 2013. What gain is recognized in the accounting year January 1 to
December 31, 2013? Each contract is on 1000 units of the commodity.

(64 - 61) x 1,000 = $3,000 gain

6. With bilateral clearing, the number of agreements between four dealers, who trade with
each other, is

Suppose the dealers are W, X, Y, and Z. The agreements are between W and X, W and Y,
W and Z, X and Y, X and Z, and Y and Z. There are therefore a total of 6 agreements.
 Chapter 5:

The convenience yield refers to the additional benefit or advantage an entity receives
from holding the physical asset (e.g., commodities) rather than owning a futures contract
on that asset. It includes benefits such as storage income, income from usage or
production, and other benefits specific to the ownership of the physical asset.

Known dividend yield on a stock: Dividends per year as a percentage of the stock price at
the time when dividends are paid are known

Backwardation: Forward price < Spot price → short asset in the spot market and buy
in the forward market

Contango: Forward price > Spot price → buy the asset in the spot market and sell in
the forward market

1. An investor shorts 100 shares when the share price is $50 and closes out the position six
months later when the share price is $43. The shares pay a dividend of $3 per share
during the six months. How much does the investor gain?

The investor gains $7 per share because he or she sells at $50 and buys at $43. However,
the investor has to pay the $3 per share dividend. The net profit is therefore 7−3 or $4 per
share. 100 shares are involved. The total gain is therefore $400.

2. The spot price of an investment asset that provides no income is $30 and the risk-free
rate for all maturities (with continuous compounding) is 10%. What is the three-year
forward price?

Forward price:
𝑟𝑇 10% × 3
𝐹0 = 𝑆0 × 𝑒 = 30 × 𝑒 = $40. 50
3. The spot price of an investment asset is $30 and the risk-free rate for all maturities is

10% with continuous compounding. The asset provides an income of $2 at the end of
the first year and at the end of the second year. What is the three-year forward price?

PV of income:
−𝑟1𝑇1 −𝑟2𝑇2 −10% × 1 −10% × 2
𝑃𝑉 = 𝐶 × 𝑒 + 𝐶 × 𝑒 =2 × 𝑒 +2 × 𝑒 = 3. 447

Forward price:
𝑟𝑇 10% × 3
𝐹0 = 𝑆0 × 𝑒 = (30 − 3. 447) × 𝑒 = $35. 84

4. An exchange rate is 0.7000 and the six-month domestic and foreign risk-free interest

rates are 5% and 7% (both expressed with continuous compounding). What is the
sixmonth forward rate?

Forward price:
(𝑟 − 𝑟𝑓)𝑇 (5% − 7%)(6/12)
𝐹0 = 𝑆0 × 𝑒 = 0. 7 × 𝑒 = 0. 693

5. A short forward contract that was negotiated some time ago will expire in three
months and has a delivery price of $40. The current forward price for three-month
forward contract is $42. The three month risk-free interest rate (with continuous
compounding) is 8%. What is the value of the short forward contract?

The contract gives one the obligation to sell for $40 when a forward price negotiated
today would give one the obligation to sell for $42. The value of the contract is the
 present value of −$2
−𝑟𝑇 −8% (3/12)
𝑓 = (𝐾 − 𝐹0) × 𝑒 = − 2× 𝑒 = − 1. 96

6. What should a trader do when the one-year forward price of an asset is too low?
Assume that the asset provides no income.

The trader should borrow the price of the asset, buy one unit of the asset and
enter into a long forward contract to buy the asset in one year.

(If the forward price is too low relative to the spot price the trader should short the
asset in the spot market and buy it in the forward market)

Forward price < Spot price → short asset in the spot market and buy in the forward
market

Forward price > Spot price → buy the asset in the spot market and sell in the forward
market

Shorting the asset in the spot market: By selling the asset in the spot market, the trader
is effectively taking a short position, expecting the price of the asset to decrease in the
future.

Buying the asset in the forward market: By simultaneously buying the asset in the
forward market, the trader locks in a future purchase price that is lower than the
expected spot price. This allows the trader to benefit from the expected increase in the
asset's price.
 Chapter 4:

1. An interest rate is 6% per annum with annual compounding. What is the equivalent rate
with continuous compounding?

𝑅𝑚 6%
𝑅𝑐 = 𝑚𝐼𝑛(1 + 𝑚
) = 1𝐼𝑛(1 + 1
) = 5. 83%

2. An interest rate is 5% per annum with continuous compounding. What is the

equivalent rate with semiannual compounding?

𝑅𝑐/𝑚 5%/2
𝑅𝑚 = 𝑚(𝑒 − 1) = 2(𝑒 − 1) = 5. 06%

3. An interest rate is 12% per annum with semiannual compounding. What is the equivalent
rate with quarterly compounding?

𝑅𝑚 12%
𝑅𝑐 = 𝑚𝐼𝑛(1 + 𝑚
) = 2𝐼𝑛(1 + 2
) = 11. 65%
𝑅𝑐/𝑚 11.65%/4
𝑅𝑚 = 𝑚(𝑒 − 1) = 4(𝑒 − 1) = 11. 82%
The equivalent rate per quarter is 1.06^0.5 -1= 2.956%. The annualized rate with
quarterly compounding is four times this or 11.83%

4. The two-year zero rate is 6% and the three-year zero rate is 6.5%. What is the forward
rate for the third year? All rates are continuously compounded.

𝑅2𝑇2 − 𝑅1𝑇1 6.5%3−6%2

Forward rate = 𝑇2 − 𝑇1
= 3−2
= 7. 5%

5. The six-month zero rate is 8% per annum with semiannual compounding. The price of a
one-year bond that provides a coupon of 6% per annum semiannually is 97. What is the
one-year continuously compounded zero rate?
 Chapter 9:
If the stock price is greater than the strike price the call is in the money and the put is out
of the money. If the stock price is less than the strike price the call is out of the money
and the put is in the money. If the stock price is equal to the strike price both options are
at the money.

1. An investor has exchange-traded put options to sell 100 shares for $20. There is a 2 for 1
stock split. Which of the following is the position of the investor after the stock split?

When there is a stock split the number of shares increases and the strike price decreases.
In this case, because it is a 2 for 1 stock split, the number of shares doubles and the strike
price halves.

→ Put options to sell 200 shares for $10

2. An investor has exchange-traded put options to sell 100 shares for $20. There is 25%
stock dividend. Which of the following is the position of the investor after the stock
dividend?

Put options to sell 125 shares for $16

The stock dividend is equivalent to a 5 for 4 stock split. The number of shares goes up by
25% and the strike price is reduced to 4/5 of its previous value.

3. An investor has exchange-traded put options to sell 100 shares for $20. There is a $1
cash dividend. Which of the following is then the position of the investor?

The investor has put options to sell 100 shares for $20

Cash dividends unless they are unusually large have no effect on the terms of an option

4. The price of a stock is $67. A trader sells 5 put option contracts on the stock with a
strike price of $70 when the option price is $4. The options are exercised when the stock
price is $69. What is the trader’s net profit or loss?

Payoff that must be made on the options = (70 - 69) x 5 x 100 = $500
Amounts received from options = 5 x 100 x 4 = $2000
Net gain = 2000 - 1500 = $500
5. The price of a stock is $64. A trader buys 1 put option contract on the stock with a strike
price of $60 when the option price is $10. When does the trader make a profit?

The payoff from exercising the put option is calculated as the difference between the
strike price and the stock price, with a minimum value of zero:

Payoff = Max(K - S0, 0)

Substituting the values:

Payoff = Max($60 - $64, 0)
Payoff = Max(-$4, 0)
Payoff = $0

Since the payoff is $0, which is less than the cost of purchasing the option ($10), the
trader does not make a profit if the stock price is above $60. In this case, the stock price
is $64, which is above the strike price.

To make a profit, the trader needs the payoff to be greater than the option price of $10.
This occurs when the stock price is below the breakeven point. Let's calculate the
breakeven point:

Breakeven Point = Strike Price - Option Price

Breakeven Point = $60 - $10
Breakeven Point = $50

→ When the stock price is below $50

 Chapter 10:

dividend is paid → reduces the value of the underlying stock because the company's
assets are distributed to shareholders → value of call options may decrease due to the
anticipated decrease in the stock price

dividend is paid → reduces the value of the stock, which can make the put option more
valuable as it provides the right to sell the stock at a predetermined price → increase the
value of put options

1. The price of a stock, which pays no dividends, is $30 and the strike price of a one year
European call option on the stock is $25. The risk-free rate is 4% (continuously
compounded). Which of the following is a lower bound for the option such that there are
arbitrage opportunities if the price is below the lower bound and no arbitrage
opportunities if it is above the lower bound?

−𝑟𝑇
𝑐 ≤ 𝑆0 − 𝐾𝑒
−4%(1)
𝑐 ≤ 30 − 25𝑒
𝑐 ≤ $5. 98

2. A stock price (which pays no dividends) is $50 and the strike price of a two year
European put option is $54. The risk-free rate is 3% (continuously compounded). Which
of the following is a lower bound for the option such that there are arbitrage opportunities
if the price is below the lower bound and no arbitrage opportunities if it is above the
lower bound?

−𝑟𝑇
𝑐 ≤ 𝐾𝑒 − 𝑆0
−3%(2)
𝑐 ≤ 54𝑒 − 50
𝑐 ≤ $0. 86
3. The price of a European call option on a non-dividend-paying stock with a strike price of
$50 is $6. The stock price is $51, the continuously compounded risk-free rate (all
maturities) is 6% and the time to maturity is one year. What is the price of a one-year
European put option on the stock with a strike price of $50?

Put-call parity:
−𝑟𝑇
𝑐 + 𝐾𝑒 = 𝑝 + 𝑆0
−6%(1)
6 + 50𝑒 = 𝑝 + 51
−−> 𝑝 = $2. 09

4. The price of a European call option on a stock with a strike price of $50 is $6. The stock
price is $51, the continuously compounded risk-free rate (all maturities) is 6% and the
time to maturity is one year. A dividend of $1 is expected in six months. What is the
price of a one-year European put option on the stock with a strike price of $50?

Put-call parity:
−𝑟𝑇
𝑐 + 𝐾𝑒 = 𝑝 + 𝑆0 − 𝐷0
−6%(1) −6%(6/12)
6 + 50𝑒 = 𝑝 + 51 − 1𝑒
−−> 𝑝 = $3. 05

5. A European call and a European put on a stock have the same strike price and time to
maturity. At 10:00am on a certain day, the price of the call is $3 and the price of the put is
$4. At 10:01am news reaches the market that has no effect on the stock price or interest
rates, but increases volatilities. As a result the price of the call changes to $4.50. Which
of the following is correct?

The put price increases to $5.50

The price of the call has increased by $1.50. From put-call parity the price of the put must
increase by the same amount. Hence the put price will become 4.00 +1.50 = $5.50.
6. Interest rates are zero. A European call with a strike price of $50 and a maturity of one
year is worth $6. A European put with a strike price of $50 and a maturity of one year is
worth $7. The current stock price is $49. Which of the following is true?

A. The call price is high relative to the put price

B. The put price is high relative to the call price
C. Both the call and put must be mispriced
D. None of the above

−𝑟𝑇
𝑐 + 𝐾𝑒 = 𝑝 + 𝑆0
6 + 50 = 7 + 49
 Chapter 11?:

● Bull spread:
○ Buy a low strike price call and sell a high strike price call
○ Buy a low strike put and sell a high strike put

● Bear spread:
○ Buy a high strike price call and sell a low strike price call
○ Buy a high strike put and sell a low strike put

butterfly spread is created when 3 different option series used. The strike prices are
usually equally spaced. The creator buys the low strike option, buys the high strike
option, and sells two of the intermediate strike option
 Chapter 12:

1. The current price of a non-dividend-paying stock is $30. Over the next six months it is
expected to rise to $36 or fall to $26. Assume the risk-free rate is zero. An investor sells
call options with a strike price of $32. Which of the following hedges the position?

The investor sells call options with a strike price of $32. If the stock price rises above
$32, the option will be exercised, and the investor will have to sell the stock at the strike
price of $32. If the stock price remains below $32, the option will expire worthless, and
the investor will keep the premium received.

Based on the given information, the value of the option will be either $4 or zero. We can
infer that the premium received from selling the call option is $4.

𝑉1𝑢 = − 𝑓1𝑢 + ∆𝑆1𝑢 = − 4 + ∆36

𝑉1𝑑 = − 𝑓1𝑑 + ∆𝑆1𝑑 = − 0 + ∆26

𝑉1𝑢 = 𝑉1𝑑

− 4 + ∆36 = − 0 + ∆26

−−> ∆ = 0. 4

→ Buy 0.4 shares for each call option sold

2. The current price of a non-dividend-paying stock is $30. Over the next six months, it is
expected to rise to $36 or fall to $26. Assume the risk-free rate is zero. What is the
risk-neutral probability of that the stock price will be $36?

36 − 30
𝑢 = 1 + 30
= 1. 2

26 − 30
𝑑 = 1 + 30
= 0. 867

𝑟𝑇 0% × 6/12
𝑒 −𝑑 𝑒 − 0.867
𝑝 = 𝑢−𝑑
= 1.2 − 0.867
= 0. 4
3. The current price of a non-dividend-paying stock is $30. Over the next six months it is
expected to rise to $36 or fall to $26. Assume the risk-free rate is zero. An investor sells
call options with a strike price of $32. What is the value of each call option?
36 − 30
𝑢 = 1 + 30
= 1. 2

26 − 30
𝑑 = 1 + 30
= 0. 867

𝑟𝑇 0% × 6/12
𝑒 −𝑑 𝑒 − 0.867
𝑝 = 𝑢−𝑑
= 1.2 − 0.867
= 0. 4

𝑓1𝑢 = max(36 - 32, 0) = 4

𝑓1𝑑 = max(32 - 36, 0) = 0

−𝑟𝑇 −0% × 6/12

𝑓0 = (𝑝𝑓1𝑢 + (1 − 𝑝)𝑓1𝑑)𝑒 = (0. 4 × 4 + (1 − 0. 4) × 0)𝑒 = $1. 6

4. The current price of a non-dividend-paying stock is $40. Over the next year, it is expected

to rise to $42 or fall to $37. An investor buys put options with a strike price of $41.
Which of the following is necessary to hedge the position?

𝑉1𝑢 = − 𝑓1𝑢 + ∆𝑆1𝑢 = − 0 + ∆42

𝑉1𝑑 = − 𝑓1𝑑 + ∆𝑆1𝑑 = − 4 + ∆37

𝑉1𝑢 = 𝑉1𝑑

− 0 + ∆42 = − 4 + ∆37

−−> ∆ = − 0. 8

→ Buy 0.8 shares for each option purchased

5. The current price of a non-dividend-paying stock is $40. Over the next year, it is expected
to rise to $42 or fall to $37. An investor buys put options with a strike price of $41. What
is the value of each option? The risk-free interest rate is 2% per annum with continuous
compounding.

42 − 40
𝑢 = 1 + 40
= 1. 05

37 − 40
𝑑 = 1 + 40
= 0. 925

𝑟𝑇 2% × 1
𝑒 −𝑑 𝑒 − 0.925
𝑝 = 𝑢−𝑑
= 1.05 − 0.925
= 0. 76

𝑓1𝑢 = max(41 - 42, 0) = 0

𝑓1𝑑 = max(41 - 37, 0) = 4

−𝑟𝑇 −2% × 1
𝑓0 = (𝑝𝑓1𝑢 + (1 − 𝑝)𝑓1𝑑)𝑒 = (0. 76 × 0 + (1 − 0. 76) × 4)𝑒 = $0. 94

6. The current price of a non-dividend paying stock is $30. Use a two-step tree to value a
European call option on the stock with a strike price of $32 that expires in 6 months.
Each step is 3 months, the risk free rate is 8% per annum with continuous compounding.
What is the option price when u = 1.1 and d = 0.9.

𝑟𝑇 8% × 3/12
𝑒 −𝑑 𝑒 − 0.9
𝑝 = 𝑢−𝑑
= 1.1 − 0.9
= 0. 601
 −𝑟𝑇 −8% × 3/12
𝑓1𝑢 = (𝑝𝑓2𝑢𝑢 + (1 − 𝑝)𝑓2𝑑𝑢)𝑒 = (0. 601 × 4. 3 + (1 − 0. 601) × 0)𝑒

𝑓1𝑢 = $2. 53

−𝑟𝑇 −8% × 3/12

𝑓1𝑑 = (𝑝𝑓2𝑑𝑢 + (1 − 𝑝)𝑓2𝑑𝑑)𝑒 = (0. 601 × 0 + (1 − 0. 601) × 0)𝑒

𝑓1𝑑 = 0

−𝑟𝑇 −8%× 3/12

𝑓0 = (𝑝𝑓1𝑢 + (1 − 𝑝)𝑓1𝑑)𝑒 = (0. 601 × 2. 53 + (1 − 0. 601) × 0)𝑒

𝑓0 = $1. 49

7. The current price of a non-dividend paying stock is $30. Use a two-step tree to value a
European put option on the stock with a strike price of $32 that expires in 6 months with
u = 1.1 and d = 0.9. Each step is 3 months, the risk free rate is 8%.

𝑟𝑇 8% × 3/12
𝑒 −𝑑 𝑒 − 0.9
𝑝 = 𝑢−𝑑
= 1.1 − 0.9
= 0. 601
 −𝑟𝑇 −8% × 3/12
𝑓1𝑢 = (𝑝𝑓2𝑢𝑢 + (1 − 𝑝)𝑓2𝑑𝑢)𝑒 = (0. 601 × 0 + (1 − 0. 601) × 2. 3)𝑒

𝑓1𝑢 = $0. 9

−𝑟𝑇 −8% × 3/12

𝑓1𝑑 = (𝑝𝑓2𝑑𝑢 + (1 − 𝑝)𝑓2𝑑𝑑)𝑒 = (0. 601 × 2. 3 + (1 − 0. 601) × 7. 7)𝑒

𝑓1𝑑 = $4. 366

−𝑟𝑇 −8%× 3/12

𝑓0 = (𝑝𝑓1𝑢 + (1 − 𝑝)𝑓1𝑑)𝑒 = (0. 601 × 0. 9 + (1 − 0. 601) × 4. 366)𝑒

𝑓0 = $2. 24

8. If the volatility of a non-dividend paying stock is 20% per annum and a risk-free rate is

5% per annum, which of the following is closest to the Cox, Ross, Rubinstein parameter
u for a tree with a three-month time step?

σ ∆𝑇 20% 3/12
𝑢 = 𝑒 = 𝑒 = $1. 1052

∆𝑇: time step

9. If the volatility of a non-dividend-paying stock is 20% per annum and a risk-free rate is
5% per annum, which of the following is closest to the Cox, Ross, Rubinstein parameter
p for a tree with a three-month time step?

σ ∆𝑇 20% 3/12
𝑢 = 𝑒 = 𝑒 = $1. 1052
1 1
𝑑= 𝑢
= 1.1052
= 0. 9048

𝑟∆𝑇 5% × 3/12
𝑒 −𝑑 𝑒 − 0.9048
𝑝 = 𝑢−𝑑
= 1.1052 − 0.9048
= 0. 538

10. The current price of a non-dividend paying stock is $50. Use a two-step tree to value an

American put option on the stock with a strike price of $48 that expires in 12 months.
Each step is 6 months, the risk free rate is 5% per annum, and the volatility is 20%.
Which of the following is the option price?

σ ∆𝑇 20% 6/12
𝑢 = 𝑒 = 𝑒 = $1. 152
1 1
𝑑= 𝑢
= 1.152
= 0. 868

𝑟∆𝑇 5% × 6/12
𝑒 −𝑑 𝑒 − 0.868
𝑝 = 𝑢−𝑑
= 1.152 − 0.868
= 0. 5539
 −𝑟𝑇 −5% × 6/12
𝑓1𝑢 = (𝑝𝑓2𝑢𝑢 + (1 − 𝑝)𝑓2𝑑𝑢)𝑒 = (0. 5539 × 0 + (1 − 0. 5539 ) × 0)𝑒

𝑓1𝑢 = $0

−𝑟𝑇 −5% × 6/12

𝑓1𝑑 = (𝑝𝑓2𝑑𝑢 + (1 − 𝑝)𝑓2𝑑𝑑)𝑒 = (0. 5539 × 0 + (1 − 0. 5539) × 10. 31808)𝑒

𝑓1𝑑 = $4. 49

−𝑟𝑇 −5%× 6/12

𝑓0 = (𝑝𝑓1𝑢 + (1 − 𝑝)𝑓1𝑑)𝑒 = (0. 5539 × 0 + (1 − 0. 5539) × 4. 49)𝑒

𝑓0 = $1. 95

11. When moving from valuing an option on a non-dividend paying stock to an option on a

currency which of the following is true?

A. The risk-free rate is replaced by the excess of the domestic risk-free rate over the
foreign riskfree rate in all calculations

B. The formula for u changes

C. The risk-free rate is replaced by the excess of the domestic risk-free rate over the

foreign risk-free rate for discounting

D. The risk-free rate is replaced by the excess of the domestic risk-free rate over the

foreign risk-free rate when p is calculated

The formula for u does not change. The discount rate does not change. The formula for p

becomes
(𝑟−𝑟𝑓)∆𝑇
𝑒 −𝑑
𝑝 = 𝑢−𝑑
 Chapter 13:

1. A stock price is $100. Volatility is estimated to be 20% per year. What

is an estimate of the standard deviation of the change in the stock
price in one week?

Estimate of the standard deviation of the change in the stock price in one week:

100 × 20% × 1/52 = $2. 77

2. Which of the following is true for a one-year call option on a stock that pays dividends
every three months?
A. It is never optimal to exercise the option early
B. It can be optimal to exercise the option at any time
C. It is only ever optimal to exercise the option immediately after an ex-dividend date
D. None of the above

When there are dividends it is sometimes optimal to exercise immediately before an

ex-dividend date, but it is never optimal to exercise at other times. None of the first three
answers are therefore correct.

3. A stock provides an expected return of 10% per year and has a

volatility of 20% per year. What is the expected value of the
continuously compounded return in one year?

The expected value of the continuously compounded return per year is

2 2
σ 20%
µ− 2
= 10% − 2
= 8%

4. An investor has earned 2%, 12% and -10% on equity investments in successive years
(annually compounded). This is equivalent to earning which of the following annually
compounded rates for the three year period.

1/𝑇
Geometric Average Return = [(1 + 𝑅1) x (1 + 𝑅2) x … x (1 + 𝑅𝑇)] −1
1/3
Geometric Average Return = [(1 + 2%) x (1 + 12%) x … x (1 - 10%)] − 1 = 0. 93%
5. When the non-dividend paying stock price is $20, the strike price is $20, the risk-free rate
is 6%, the volatility is 20% and the time to maturity is 3 months which of the following is
the price of a European call option on the stock

𝑆0 2
σ 20
2
20%
𝑙𝑛( 𝐾
) + (𝑟 + 2
)𝑇 𝑙𝑛( 20 ) + (6% + 2
)3/12
𝑑1 = = = 0. 2
σ 𝑇 0.2 3/12

𝑑2 = 𝑑1 − σ 𝑇 = 0. 2 − 20% 3/12 = 0. 1

Option price:
−𝑟𝑇 −6%(3/12)
𝑆0𝑁(𝑑1) − 𝐾𝑒 𝑁(𝑑2) = 20𝑁(0. 2) − 20𝑒 𝑁(0. 1)

→ 20N(0.2) - 19.7N(0.1)

6. When the non-dividend paying stock price is $20, the strike price is $20, the risk-free rate
is 6%, the volatility is 20% and the time to maturity is 3 months which of the following is
the price of a European put option on the stock

𝑆0 2
σ 20
2
20%
𝑙𝑛( 𝐾
) + (𝑟 − 2
)𝑇 𝑙𝑛( 20 ) + (6% − 2
)3/12
𝑑1 = = = 0. 2
σ 𝑇 0.35 3/12

𝑑2 = 𝑑1 − σ 𝑇 = 0. 2 − 20% 3/12 = 0. 1

Option price:
−𝑟𝑇 −6%(3/12)
𝐾𝑒 𝑁(− 𝑑2) − 𝑆0𝑁(− 𝑑1) − = 20𝑒 𝑁(− 0. 1) − 20𝑁(− 0. 2)

→ 19.7N(-0.1) - 20N(-0.2)
7. A stock price is 20, 22, 19, 21, 24, and 24 on six successive Fridays. Which of the
following is closest to the volatility per annum estimated from this data?

The price relative for the first week is 22/20 or 1.1. The natural log of the price relative is

ln(1.1) or 0.09531.

ln(19/22) = -0.1466

ln(21/19) = 0.1001

ln(24/21) = 0.1335

ln(24/24) = 0

mode 6 → 1 add

Optn → 3 → choose S(X)

0.1138 x 52 = 82%

0.1138. The volatility per week is therefore 11.38%. This corresponds to a volatility per
year

of 0.1138 multiplied by the square root of 52 or about 82%. The answer is therefore D.

8. The volatility of a stock is 18% per year. Which is closest to the volatility per month?

Volatility per month: 18% × 1/12 = 5. 2%

The volatility per month is the volatility per year multiplied by the square root of 1/12 .
The square root of 1/12 is 0.2887 and 18% multiplied by this is 5.2%