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19.

17. CHAPTER 4: OPTION PRICING MODELS: THE BINOMIAL MODEL


19. END-OF-CHAPTER QUESTIONS AND PROBLEMS
20.
21. 1. (Two-Period Binomial Model) In a recombining tree, if the underlying first moves up and then
down, it will be at the same price as in the case when it first moves down and then up. In a non-
recombining tree, the underlying will not be at the same price in those two cases. A recombining tree will
have far fewer possible prices of the underlying. For a recombining tree of n time steps, there will be n + 1
possible final prices. For a non-recombining tree of n time steps, there will be 2 n possible final prices. It is
far more practical to work with a recombining tree, because the number of time steps is likely to be a more
manageable number.
22.
23. 2. (One-Period Binomial Model) The up and down factors reflect a spread between the next two
possible stock prices. That spread is an indication of the volatility. It is easy to see that if we increase u
and/or decrease d, we increase the volatility.
24.
25. 3. (Extending the Binomial Model to n Periods) If the up and down parameters were not adjusted,
the stock would have unreasonable volatility. For example, suppose u = 1.25 and d = 0.80 and the period of
time is one year. Then one year later, a $100 stock would be at $125 or $80. If we now went to a two-
period model, dividing the options life into two six-month periods, we could not maintain u and d at their
current values. Otherwise, the stock could get as high as $100(1.25) 2 = $156.25 or as low as $100(0.80)
(0.80) = $64. If, however, we are letting the binomial period be one year but then want to work with a two-
year option, we would maintain u and d at 1.25 and 0.80 since it would then be realistic to allow values as
high as $156.25 and $64 over two years. While this problem might not appear to be that significant in a
one- or two-period situation, if we are using many periods, we are admitting an unreasonable degree of
volatility if we do not adjust u and d.
26.
27. 4. (Dividends) There are two ways using discrete dividends and one way using continuous
dividends. For discrete dividends, we can specify that the dividend is a constant percentage of the stock
price. At each time step, the stock price moves up or down and then makes an immediate fall by the
amount of the dividend. In other words, let us say a $100 stock could move up or down by 10 percent and
that there is a 5 percent dividend. So the next period the stock moves up to $110 or down to $90. Without
leaving that time point, however, it immediately drops to 0.95($110) = $104.50 or 0.95($90) = $85.50. So
we replaced $110 by $104.50 and $90 by $85.50. The tree would still recombine. From $104.50 it could
move down to (0.90)$104.50 = $94.05, and from $85.50, it could move up to (1.10)($85.50) = $94.05.
28.
29. Alternatively, we could specify that the dividend is a fixed dollar amount. Unfortunately, if we do
it this way, the tree will no longer recombine. That is, up followed by down is no longer the same as down
followed by up. For example, in the above case, let the dividend just be $5. Then the stock goes to $110 or
$90. Replace these values by the ex-dividend values of $105 and $85. Now let it move again up 10
percent or down 10 percent. Then from $105 it would go down to 0.90($105) = $94.50. From $85 it would
move up to (1.10)($85) = $93.50.
30.
31. An alternative approach that would handle this problem is to let the up and down factors apply
only to the stock price minus the present value of the dividends. Let the risk-free rate be 5%. Then the
present value of the $5 dividend is $5/1.05 = $4.76. Now the stock price minus the present value of the
dividends is $100 $4.76 = $95.24. It can now go up to $95.24(1.10) = $104.76 or down to $95.24(0.90) =
$85.72. At those points the actual stock price is really $104.76 + $5 = $109.76 and $85.72 + $5 = $90.72.
Then when the stock goes ex-dividend, the price falls to $104.76 or $85.72. Then from $104.76 it can go
down to (0.90)$104.76 = $94.28. From $85.72 it can go up to (1.10)($85.72) = $94.29, with the difference
being only a rounding error.
32.

20. Chapter 4 17 End-of-Chapter Solutions


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in whole or in part.
22.
19.
33. 5. (One-Period Binomial Model) a. 25(1.15) = 28.75 25(0.85) = 21.25
34.
35. b. Max(0, 28.75 25) = 3.75
36. Max(0, 21.25 25) = 0
37.
c. p = (1.10 0.85)/(1.15 0.85) = 0.8333, 1 p = 0.1667
38.
(0.8333)3. 75 (0.1667)0
C 2.84
39. 1.10
40.
d. h = (3.75 0.0)/(28.75 21.25) = 0.50
41.
42. So buy 500 shares and sell 1,000 calls
43.
44. V = 500(25) 1,000(2.84) = 9,660
45. Vu = 500(28.75) 1,000(3.75) = 10,625
46. Vd = 500(21.75) 1,000(0.0) = 10,625
47.
48. Rh = (10,625/9,660) 1 0.10
49.
e. V will then be
50.
51. 500(25) 1,000(3.50) = 9,000
52.
53. At expiration, Vu (and Vd) will still be 10,625 so
54.
55. Rh = (10,625/9,000) 1 0.18
56.
57. 6. (Two-Period Binomial Model) a.
S 45, Su 45(1.10) 49.5, Su 2 45(1.10) 2
54.45
2 2
Sd 45(.9) 40.5, Sd 45(.9) 36.45
Sud 45(1.10)(. 9) 44.55
58.
59.
60. b.
C u 2 Max(0,54.4 5 40) 14.45
C ud Max(0,44.5 5 40) 4.55
C d 2 Max(0,36.4 5 40) 0
61.
62.
63. c.
p ((1 r) d)/(u d) (1.05 .9)/(1.10 .9) .75
1 p 1 .75 .25
C u (C u 2 p C ud (1 p))/(1 r)
(14.45(.75 ) 4.55(.25)) /1.05 11.40
C d (C ud p C d 2 (1 p))/(1 r)

64. (4.55(.75) 0(.25))/1. 05 3.25

20. Chapter 4 18 End-of-Chapter Solutions


21. 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
22.
19.
65.
66. d.
C (C u p C d (1 p))/(1 r)
(11.40(.75 ) 3.25(.25)) /1.05 8.92
67.
68.
69. e.
h (C u Cd )/(Su Sd)
(11 .40 3.25) /(49 .5 40 .5) .9056
70.
71.
72. f. If the stock goes up
73.
h u (C u 2 C ud )/(Su 2 Sud)

74. (14 .45 4.55 ) /(54 .45 44 .55 ) 1

17. If the stock goes down


h d (C ud C d 2 )/(Sud Sd 2 )

18. (4.55 0)/(44.55 36.45) .5617

75.
76. h. Buy 906 shares and write 1,000 calls
77.
78. Value of portfolio today:
79.
80. 906(45) 1,000(8.92) = 31,850
81.
82. Value of portfolio one period later:
83.
84. If stock goes up,
85.
86. 906(49.50) 1,000(11.40) = 33,447
87.
88. If the stock goes down,
89.
90. 906(40.50) 1,000(3.25) = 33,443
91.
92. These two amounts are essentially equivalent.
93.
94. Return over one period = (33,447/31,850) 1 0.05
95.
96. If stock goes up to 49.5, h u = 1. Then buy 94 calls at 11.40 for $1,072. Borrow the
money at the risk-free rate. Now you have 906 shares and 906 calls, which is a hedge ratio of 1.
Your portfolio is:
97.
98. 906 shares at 49.50 = 44,847
99. 906 calls at 11.40 = 10,328
100. loan = 1,072
101. 33,447
20. Chapter 4 19 End-of-Chapter Solutions
21. 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
22.
19.
102.
103. Value of portfolio one period later:
104.
105. If stock goes up,
106.
107. 906(54.45) 906(14.45) 1,072(1.05) = 35,114
108.
109. If stock goes down,
110.
111. 906(44.55) 906(4.55) 1,072(1.05) = 35,114
112.
113. If the stock had gone down in the first period to 40.50, then h d = 0.562. Then sell 344
shares at 40.50. Take the proceeds of 13,932 and invest this amount for the next period in risk-free
bonds earning 5 percent. Now you have 562 shares and 1,000 calls, which is a hedge ratio of
0.562. Your portfolio is:
114.
115. 562 shares at 40.50 = 22,761
116. 1,000 calls at 3.25 = 3,250
117. bonds = 13,932
118. 33,443
119.
120. Value of the portfolio at the end of the second period:
121.
122. If stock goes up,
123.
124.562(44.55) 1,000(4.55) + 13,932(1.05) = 35,116
125.
126. If stock goes down,
127.
128.562(36.45) + 13,932(1.05) = 35,114
129.
130. The difference between 35,114 and 35,116 is due to rounding.
131.
35,114 / 31,850 1 0.05
132. Return over one period =
133.
134. If it were overpriced, the investor should establish the same riskless hedge by buying 906
shares and writing 1,000 calls. If it were underpriced, the investor should buy 1,000 calls and sell
short 906 shares. This would create a type of loan in which money is received today and paid
back later. The effective rate on the loan would be less than the risk-free rate.
135.
136. 7. (Two-Period Binomial Model)

20. Chapter 4 20 End-of-Chapter Solutions


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in whole or in part.
22.
19.
Su = 30(1.15)(1 - .06) = 32.43, Sd = 30(.9)(1 - .06) = 25.38
Su 2 = 32.43(1.15 ) = 37.29, Sd 2 = 25.38(.9) = 22.84
Sud = 32.43(.9) or 25.38(1.15 ) 29.19
C u 2 = Max(0, 37.29 - 25) = 12.29, C ud = Max(0, 29.19 - 25) = 4.19
C d2 = Max(0, 22.84 - 25) = 0
p = (1.05 - .9)/(1.15 - .9) = .6
.6(12.29) + .4(4.19)
Cu = = 8.62
1.05
but at time 1 in the top state, the stock is at 30(1.15) 34.50 before it goes ex - dividend. So
exercise the call for 34.50 - 25 9.50. Thus, C u 9.50
.6(4.19 ) .4(0)
Cd 2.39
1.05
.6(9.50 ) .4(2.39 )
C 6.34
137. 1.05

138.
139. 8. (Two-Period Binomial Model)
140.
Su 62(1.10) 68.20
Sd 62(.95) 58.90
Su 2 68.20(1.10 ) 75.02
Sd 2 58.90(.95) 55.96

141. Sud 68.20(.95) 64.79

142.
p = (1.08 - .95)/(1.10 - .95) = .8667
Pu 2 = Max(0, 70 - 75.02) = 0
Pud = Max(0, 70 - 64.79) = 5.21
Pd 2 = Max(0, 70 - 55.96) = 14.04
.87(0) + .13(5.21)
Pu = = .63,
143. 1.08
144. but worth Max(0,70 68.2) = 1.80 if exercised so Pu = 1.80.
145.
.87(5.21) + .13(14.04)
Pd = = 5.89
146. 1.08
147.
148.
149. but worth Max(0,70 58.90) = 11.10 if exercised so Pd = 11.10.
150.
.87(1.80) + .13(11.10)
P= = 2.79
151. 1.08

20. Chapter 4 21 End-of-Chapter Solutions


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in whole or in part.
22.
19.
152.
153. but worth Max(0,70 62) = 8 if exercised so P = 8.
154.
155. 9. (Two-Period Binomial Model)
Su 60(1.15) 69
Sd 60(0.80) 48
Su 2 60(1.15) 2
79.35
Sud 60(1.15)(0 .80) 55.20

156. Sd 2 60(0.80) 2
38.40
157.
p (1.10 0.80)/(1.1 5 0.80) .857
C u 2 Max(0,79.3 5 50) 29.35
C ud Max(0,55.2 0 50) 5.20
C d 2 Max(0,38.4 0 50) 0
158.
159.
.857(29.35 ) .143(5.20)
Cu 23.54
1.10
.857(5.20) .143(0.0)
Cd 4.05
1.10
.857(23.54 ) .143(4.05)
C 18.87
160. 1.10
161.
23.54 4.05
h .928
69 48
29.35 5.20
hu 1.00
79.35 55.20
5.20 0.0
hd .3095
162. 55.20 38.40
163.
164. At time 0, h = 0.928. Let us buy 928 shares at 60 and sell 1,000 calls at 18.87. Then the
value is
165.
166. 928(60) 1,000(18.87) = 36,810
167.
168. At time 1 when the stock is 69, the portfolio is worth
169.
170. 928(69) 1,000(23.54) = 40,492
171.
172. The new hedge ratio is 1.0. Let us buy 72 shares at 69, costing 4,968, which we borrow. Our
position is now 1000 shares, 1000 short calls, and a loan of 4,968.
173.
174. At time 2 when the stock goes from 69 to 79.35, the portfolio is worth
175.
176. 1000(79.35) 1000(29.35) 4,968(1.10) = 44,535
177.
20. Chapter 4 22 End-of-Chapter Solutions
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in whole or in part.
22.
19.
178. At time 2 when the stock goes from 69 to 55.20, the portfolio is worth
179.
180. 1000(55.20) 1000(5.20) 4,968(1.10) = 44,535
181.
182. At time 1 when the stock is 48, the portfolio is worth
183.
184. 928(48) 1,000(4.05) = 40,494
185.
186. The new hedge ratio is 0.310. Let us sell the shares to generate 618(48) = 29,664 and invest this in
bonds. Our position is now 310 shares, 1000 short calls and 29,664 invested in bonds.
187.
188. At time 2 when the stock goes from 48 to 55.20, the portfolio is worth
189.
190. 310(55.20) 1,000(5.20) + 29,664(1.10) = 44,542
191.
192. At time 2 when the stock goes from 48 to 38.40, the portfolio is worth
193.
194. 310(38.40) 1,000(0.0) + 29,664(1.10) = 44,534.
195.
196. Thus, at time 1 the 36,810 grew to 40,492 (or 40,494, a round off difference), which is 10 %.
From time 1, the 40,492 grew to 44,542 (or 44,535 or 44,534, round off differences), a return of 10%.
197.
198. 10. (Extending the Binomial Model to n Periods)
T/n
199. ue
200.
201. n u d r
202. 1 1.7333 0.5769 .07
203. 5 1.2789 0.7819 .0136
204. 10 1.1900 0.8404 .0068
205. 50 1.0809 0.9252 .0014
206. 100 1.0565 0.9465 .0007
207.
208. 11. (Extending the Binomial Model to n Periods)
209. Inserting the proper values into the spreadsheet gives the following:
210.
211. n C
1 10.4603
5 9.0585
10 8.5365
25 8.7720
50 8.6721
212.
213. 12. (American Puts and Early Exercise)
214.
S = 125.94 X = 130 r = .0456 T = 0.0959 = 0.83
215.
216. Adjusting the risk-free rate: r = (1.0456)0.0959/2 1 = 0.0021
217.
218. The up and down factors:
219.

20. Chapter 4 23 End-of-Chapter Solutions


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in whole or in part.
22.
19.
u e 0.83 0.0959/2
1.1993
220. d 1/1.1993 0.8338
221.
222. We know that p = 0.4605 from the text. Therefore,
223.
224. Su = 125.94(1.1993) = 151.0398
225. Sd = 125.94(0.8338) = 105.0088
226. Su2 = 125.94(1.1993)2 = 181.1421
227. Sud = 125.94(1.1993)(0.8338) = 125.9370
228. Sd2 = 125.94(0.8338)2 = 87.5563
229.
230. Pu2 = Max(0, 130 181.1421) = 0.0
231. Pud = Max(0, 130 125.9370) = 4.063
232. Pd2 = Max(0, 130 87.5563) = 42.4437
233.
0.4605 0 0.5395 4.063
Pu 2.1874
234. 1.0021
0.4605 4.063 0.5395 42 .4437
Pd 24 .7175
235. 1.0021
236.
237. But it can be exercised here for 130 105.0088 = 24.9912, therefore Pd = 24.9912 and
238.
0.4605 2.1874 0.5395 24 .9912
P 14 .4597
239. 1.0021
240.
241. 13. (Advantages of the Binomial Model) Concept illustration advantages:
242.
Visualize how the construction of a dynamic risk-free hedge leads to a formula for the option price
The probability of stock price movements does not play a role in option pricing.
Because the probability of the stock price movement is irrelevant, the binomial model shows that
option valuation is consistent with risk neutrality.
243.
244. Practical implementation advantages:
245.
Particularly useful in handling American options, because investors may decide to exercise these
options early. One can easily check if early exercise is advantageous at each location in the
binomial tree.
Dividends can easily be incorporated into the binomial model.
Useful in valuing complex options
246.
247. 14. (Chapter 3, Spreadsheets) Using the spreadsheet, we find the call price is 14.2836 and the put
price is 9.5217. Recall from Chapter 3,
248.
249. Ce = S0 X(1+r)-T + Pe
250.
251. which in this case implies
252.
253. 14.2836 =100 100(1+0.05)-1 + 9.5217 = 14.2836
20. Chapter 4 24 End-of-Chapter Solutions
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in whole or in part.
22.
19.
254.
255. and put-call parity does hold.
256.
257. 15. (One- Period Binomial Model) Recall that the value of p = (1+r-d)/(u-d) which in this case
equals 51.44%. The hedge ratio varies by the strike price and is 0.743 (X=90), 0.571 (X=100), and 0.400
(X=110). Thus the hedge ratio declines as the strike price increases, but the probability p does not change.
258.
259. 16. (One- Period Binomial Model) Recall that the value of p = (1+r-d)/(u-d). However, the value of r
is the periodic rate which varies depending on the maturity of the option. Thus, in this case the periodic
rate is 2.47% (T=0.5), 5.00% (T=1), and 7.59% (T=1.5). Therefore the probability p is 50.97% (T=0.5),
51.44% (T=1.0), and 51.85% (T=1.5). The hedge ratio does not vary by the time to maturity and is 0.571.
Thus the hedge ratio declines as the strike price increases, but the probability p does not change.
260.
261. 17. (Extensions of the Binomial Model) First let us find the value of p:
262.
263. p = (1.08 0.90)/(1.20 0.90) = 0.60
264.
265. The stock prices can be easily found by starting at 75 and going up by a factor of 1.20 and down
by a factor of 0.90. This will lead to a tree that looks like this:
266.
267. 129.60
268. 108
269. 90 97.20
270. 75 81
67.50 72.90
271. 60.75
272. 54.675
273.
274. In the top state at time 3, the payoff for a standard European call would be 59.60 but this option
limits the payoff to 40. So we put 40 in the top state. All other payoffs at time 3 are the same. Working
back through the tree gives values of
275.
276. 40
277. 32.30
278. 23.94 27.20
279. 16.85 16.19
280. 9.59 2.90
281. 1.61
282. 0.0
283.
284.
285. For the American version of this option, we have to check and see if early exercise is justified at
any time point. In fact it would be when the stock is at 108 and at 90. Note that at 108, the option could be
exercised for a value of 108 70 = 38, which is still below the 40 limit but above the value shown above of
32.30. Nowhere else would it be exercised early, but the value at 90 and at 75 would still differ since we
replaced 32.30 at time 2 with 38. Now the tree would look like:
286.
287. 40
288. 38
289. 27.11 27.20
290. 18.61 16.19

20. Chapter 4 25 End-of-Chapter Solutions


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in whole or in part.
22.
19.
9.592.90
291. 1.61
292. 0.0
293.
294. For the European option without the maximum payout limitation, we have the following tree:
295.
296. 59.60
297. 43.19
298. 29.99 27.20
299. 20.21 16.19
300. 9.59 2.90
301. 1.61
302. 0.0
303.
304. 18. (Hedge Portfolio) Let B be the amount issued in bonds. Then the initial portfolio has a value of
305.
306. V = nSS B.
307.
308. Since we want this to replicate the call, we require that
309.
310. Cu = nSSu B(1 + r)
311. Cd = nSSd B(1 + r).
312.
313. Solve for B and nS:
314.
C u Cd
nS
Su Sd
C Cd
Cu u Su
Su Sd
B
315. 1 r
316.
317. Since V = nSS B and the replicating portfolio must be equivalent to a call, we must have C = nSS
B. Substituting our formulas for nS and B, with a great deal of algebra we obtain
318.
pCu (1 p)C d
C .
319. 1 r
320.
321. If you did not get the algebra, do not worry about it. The important point is how the problem is set up.
322.

20. Chapter 4 26 End-of-Chapter Solutions


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22.

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