ACTS 4302

Instructor: Natalia A. Humphreys

SOLUTION TO HOMEWORK 3
Lesson 4: Binomial Trees - General
Lesson 5: Other valuation methods of pricing options.
Problem 1
For a 1-year European put option on a stock modeled with a binomial tree:
(i) The tree has 2 periods.
(ii) The tree is constructed based on forward prices.
(iii) The stock price is 50.
(iv) The strike price is 53.
(v) The continuously compounded risk-free rate is 3%.
(vi) The stock pays dividends at continuously compounded rate of 1%.
(vii) = 0.2
Determine the option premium.
Solution.
Let us first calculate u, d and .

u = e(r)h+ h = e0.020.5+0.2 0.5 = e0.1514 = 1.1635

d = e(r)h h = e0.020.50.2 0.5 = e0.1314 = 0.8768
1
1
=

p =
= 0.4647

h
1 + e0.2 0.5
1+e
1 p = 0.5353
The stock tree:
u2 S = 67.6851
uS = 58.1743
S = 50

udS = 51.0101
dS = 43.8424
d2 S = 38.4431

The put tree:

Puu = 0
Pu
Pud = 1.9899

P
Pd

Pdd = 14.5569

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 3.

Copyright Natalia A. Humphreys, 2014

We now use the formula for pricing an option with risk neutral probability:
Pu = erh (p Puu + (1 p )Pud ) = e0.030.5 (0.4647 0 + 0.5353 1.9899) = 1.0493
Pd = erh (p Pud + (1 p )Pdd ) = e0.030.5 (0.4647 1.9899 + 0.5353 14.5569) = 8.5872
P = erh (p Pu + (1 p )Pd ) = e0.015 (0.4647 1.0493 + 0.5353 8.5872) = 5.0086 5.01

Problem 2
A 1-year American call option on a stock is modeled with a 12-period binomial tree. You are given:
(i) The tree is constructed based on forward prices.
(ii) The stock price is 90.
(iii) The strike price is 135.
(iv) The continuously compounded risk-free rate is 5%.
(v) The stock pays no dividends.
(vi) = 0.12
Calculate the option premium.
Hints:
1. Use the probabilities at the nodes where the option is not zero and calculate the present value of
the expected value of the ending call value.
2. Also, if the stock has no dividends, it is never rational to exercise the option early.
Solution. Note that if the stock has no dividends, it is never rational to exercise the option early.
In that case CAmer = CEur . Let us first calculate u, d and p .
u=e

(r)h+ h

q
1
1
+0.12 12
0.05 12
e
q
1
1
0.05 12
0.12 12

= e0.0388 = 1.0396

d = e(r)h h = e
= e0.0305 = 0.9700
1
1
q
=
p =
= 0.4913
1
0.12 12
1 + e h
1+e
1 p = 0.5087
Note that
u12 S = 1.039612 90 = 143.38 Cu12 = 8.3805
But
u11 dS = 1.039611 0.97 90 = 133.78 < 135 Cu11 d = 0
Therefore, all other end values of C at the end nodes are zeros. Using the probabilities at the end
nodes, the call value is:
C = erT (p )12 Cu12 = e0.05 0.491312 8.3805 = 0.001578

Problem 3
A 1.5-year euro-denominated currency American put option to sell dollars is modeled with a 2-period
binomial tree. You are given:
(i) The spot exchange rate is 0.85 e/$.
(ii) This exchange rate is expected to go up by 11% or down by 11%.
(iii) re = 0.055.
(iv) r$ = 0.06.
(v) The strike price is 0.9 e/$.
Determine the options premium.
Solution.
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ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 3.

We are given:
u = 1.11, d = 0.89 u d = 0.22
T = 1.5, n = 2 h = 0.75
re = rd = r = 0.055, r$ = rf = = 0.06, x0 = 0.85
The spot exchange rate tree:
u2 x0 = 1.0473
ux0 = 0.9435
x0 = 0.85

udx0 = 0.8397
dx0 = 0.7565
ddx0 = 0.6733

The put tree:

Puu = 0
Pu
Pud = 0.0603

P
Pd

Pdd = 0.2267
Let us find the risk neutral probability of the up movement of the exchange rate:
e(r)h d
e(0.0550.06)0.75 0.89
e0.0038 0.89
=
=
= 0.483;
ud
0.22
0.22
1 p = 0.517
p =

We now use the formula for pricing an option with risk neutral probability:
Pu = erh (p Puu + (1 p )Pud ) = e0.0550.75 0.517 0.0603 = 0.03
Pd = erh (p Pud + (1 p )Pdd ) = e0.0550.75 (0.483 0.0603 + 0.517 0.2267) = 0.1404
Let us check for early exercise. At node u, if the option is exercised, its value is 0. Thus, exercise
is not optimal and we use Pu = 0.03 in calculating P . At node d, if the option is exercised, its
value is 0.9 0.7565 = 0.1435. Since 0.1435 > 0.1404, exercise is optimal and we use Pd = 0.1435 in
calculating P . Thus,
P = erh (p Pu + (1 p )Pd ) = e0.04125 (0.483 0.03 + 0.517 0.1435) = 0.0851
We now check if exercise at the initial node is optimal. If exercised, the option value is 0.9 0.85 =
0.05 < 0.0851. The exercise is not optimal and the answer remains P = 0.0851. 
Problem 4
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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 3.

A 1-year American put option on a 1-year futures contract is modeled with a 2-period binomial tree.
You are given:
(i) The tree is constructed based on forward prices.
(ii) The underlying stock price is 780.
(iii) The strike price is 800.
(iv) The continuously compounded risk-free rate is 4%.
(v) The underlying stock pays no dividends.
(vi) = 0.3
Determine the option premium.
Solution.
Let us first determine the value of the future. By definition, the price of a future on a dividend paying
stock with continuous dividends:
Ft,T = Se(r)T = 780e0.04 = 811.83
Also, u, d and p are:

h
= e0.3 0.5 = 1.2363
u = e
d = e h = e0.1 0.5 = 0.8089
1d
1 0.8089
p =
=
= 0.4472
ud
1.2363 0.8089
1 p = 0.5528

The spot exchange rate tree:

u2 F = 1240.86
uF = 1003.68
F = 811.83

udF = 811.83
dF = 656.66
dF = 531.14

The put tree:

Puu = 0
Pu
Pud = 0

P
Pd

Pdd = 268.86
Let us now calculate the values of the Put at nodes u and d.
Pu = 0
Pd = erh (p Pud + (1 p )Pdd ) = e0.040.5 0.5528 268.86 = 145.69
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Let us check for early exercise. At node u, if the option is exercised, its value is 0. Its the same as
the calculated value Pu = 0. At node d, if the option is exercised, its value is 800 656.66 = 143.34.
Since 143.34 < 145.69, exercise is optimal and we use Pd = 145.69 in calculating P . Thus,
P = erh (p Pu + (1 p )Pd ) = e0.02 0.5528 145.69 = 78.95
We now check if exercise at the initial node is optimal. If exercised, the option value is max(0, 800
811.83) = 0 < 78.95. The exercise is not optimal and the answer remains P = 78.95 
Problem 5
A 1-year European call option is modeled with the 3-period binomial tree shown in Figure below.
The numbers on the ending nodes are the prices of the option at those nodes.
You are also given:
(i) The risk neutral probability of an up move is 0.4.
(ii) The continuously compounded risk-free interest rate is 0.03.
Compute the premium for the call.
35

20

10

Solution.
As in Problem 2, we will use the probabilities at the end nodes and calculate the present value of the
expected value of the ending call value.

uuu

3
3

(p )3 = 0.43 = 0.064

uud

3
2

(p )2 (1 p ) = 3 0.42 0.6 = 0.288

udd

3
1

(p ) (1 p )2 = 3 0.4 0.62 = 0.432

ddd

3
2

(1 p )3 = 0.63 = 0.216

Therefore, the call value is:

C = e0.03 (35 0.064 + 20 0.288 + 3 +10 0.432 + 0 0.216) =
= 11.9559 11.96 
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ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 3.

Problem 6
An 8-month put option on a stock is modeled with a 1-period binomial tree. You are given:
(i) The continuously compounded risk-free rate is 3.5%.
(ii) The continuously compounded rate of return for the put option is -4%.
(iii) The stock pays no dividends.
(iv) The strike price equals the current stock price.
(v) = 0.25
(vi) The binomial tree is constructed using forward prices.
Calculate the continuously compounded rate of return for the stock.
Solution. We are given: T = 0.67, n = 1, r = 0.035, = 0.04, = 0, K = S, = 0.25.
We need to find .
Since the binomial tree is constructed using forward prices, we have:

u = e(r)h+ h = e0.0350.67+0.25 0.67 = e0.2275 = 1.2554

d = e(r)h h = e0.0350.670.25 0.67 = e0.1808 = 0.8346
u d = 0.4208
Probability that the stock will increase in value
p=

e()h d
e0.67 0.8346
=
ud
0.4208

On the other hand,

p =

1
1 + e

0.67

1 + e0.25

= 0.4491, 1 p = 0.5509

We can find p from

(1)

eh (pPu + (1 p)Pd ) = erh (p Pu + (1 p )Pd )

Note that
Pu = max(0, K Su) = max(0, S(1 u)) = 0, since u > 1
Pd = max(0, K Sd) = 0.1654 S
Therefore, (1) could be written as:
eh (1 p) = erh (1 p ) p = 1 e(r)h (1 p )
p = 1 e(0.040.035)0.67 0.5509 = 0.476
We now have an equation for :
e0.67 0.8346
= 0.476 e0.67 = 1.0349 = 0.0515
0.4208

Problem 7
A 1-year European call option on a stock is valued with a 1-period binomial tree. You are given:
(i) The stock price is 42.
(ii) The strike price is 49.
(iii) In the binomial tree, u = 1.2, and d = 0.8.
(iv) The continuously compounded rate of return for the stock is 0.10.
(v) The continuously compounded rate of return for the call option is 0.26.
(vi) The continuous dividend rate for the stock is 0.03.
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ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 3.

Determine the continuously compounded risk-free rate.

(A) 4.5%

(B) 5.1%

(C) 11.6%

(D) 13.4%

(E) 15.0%

Key: B
Solution. We are given: T = 1, n = 1 h = T /n = 1, S = 42, K = 49, u = 1.2, d = 0.8, =
0.10, = 0.26, = 0.03, u d = 0.4. We need to find r.
The stock tree:
uS = 50.4
S = 42
dS = 33.6
The call tree:
Cu = 1.4
C
Cd = 0
Using equation that connects p and p :
eh (pCu + (1 p)Cd ) = erh (p Cu + (1 p )Cd ) eh p = erh p
Using formulas for p and p :
e()h d
e(0.100.03)1 0.8
=
= 0.6813
ud
0.4
e(r)h d
e(r0.03)1 0.8
p =
=
ud
0.4
p=

Therefore,


e(r0.03) 0.8
er e(r0.03) 0.8 = 0.2101
0.4
= 0.7603 er = 0.9504 r = 0.0509 0.051 = 5.1% B

eh p = erh p 0.6813e0.26 = er
e0.03 0.8er = 0.2101 0.8er

Problem 8
You are given:
(i) A stock pays dividends at a continuous rate of 0.025.
(ii) The stock price is 27.
(iii) The stocks price may increase to 31 or decrease to 21 in one year.
(iv) The continuously compounded rate of return on the stock is 0.16.
(v) The continuously compounded risk-free rate is 0.045.
(vi) A one-year call option on the stock has strike price 12.
Determine the continuously compounded rate of return on the option.
Solution. We are given:
= 0.025, S = 27, Su = 31, Sd = 21, = 0.16
r = 0.045, T = 1, K = 12
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ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 3.

If is the annual return of an option, then

C = eh (pCu + (1 p)Cd )
The stock tree:
uS = 31
S = 27
dS = 21
The call tree:
Cu = 19
C
Cd = 9
Calculating u and d,
u=

31
21
= 1.1482, d =
= 0.7778, u d = 0.3704
27
27

Note that
e()h d
e(0.160.025)1 0.7778
=
= 0.9902
ud
0.3704
1 p = 0.0098

p=

Hence,
C = eh (pCu + (1 p)Cd ) = e (0.9902 19 + 0.0098 9) = 18.9025e
On the other hand, we can evaluate C as C = S + B, where


Cu Cd
19 9 0.025
=
eh =
e
= 0.9753
S(u d)
10


1.1482 9 0.7778 19
rh uCd dCu
B=e
= e0.045
= 11.472
ud
0.3704
Hence, C = 27 0.9753 11.472 = 14.8614.
Note that, since the option pays off at both nodes, the put option is worthless and, hence, we could
also evaluate C from the PCP:
C = Seh Kerh = 27e0.025 12e0.045 = 26.3333 11.472 = 14.8614.
Solving 18.9025e = 14.8614, we obtain: = 0.2405 0.24

.

Problem 9
For a call option, you are given that after one year it may be worth 0 or 30. The present value of
the utility of 1 is 0.98 in the lower state and 0.94 in the higher state. The probability of 30 is 0.4.
Calculate the risk-neutral probability of 30.
Solution. By formula
p =

pUH
,
pUH + (1 p)UL
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ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 3.

we have:
p =

Copyright Natalia A. Humphreys, 2014

0.4 0.94
= 0.39
0.4 0.94 + 0.6 0.98

Problem 10
For a dividend paying stock, you are given:
(i) After 1 year, only two prices are possible: 60 or 80.
(ii) The present value of the utility of 1 is 0.91 in the lower state and 0.82 in the higher state.
(iii) The risk-neutral probability of 80 is 0.45.
Calculate the true annual effective rate of return on the stock.
Solution. By equation
p=

p UL
p UL + (1 p )UH

we have:

0.45 0.91
= 0.4759, 1 p = 0.5241
0.45 0.91 + 0.55 0.82
The rate of return, by formula
pCH + (1 p)CL
1
=
pUH CH + (1 p)UL CL
is the probability-weighted ending value divided by the probability and utility-weighted starting value,
minus 1.
0.4759 80 + 0.5241 60
69.5177
=
=
1 = 0.1618 
0.4759 0.82 80 + 0.5241 0.91 60
59.8347
p=

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