SAMPLE PROBLEMS

1. A stock price is now $40. At the end of one month it will be either $42 or $38. The risk-free interest rate is 8% per annum with continuous compounding. What is the value of a one-month European call option with a strike price of $39? 2. A stock price is now $50. At the end of six months it will be either $45 or $55. The risk free interest rate is 10% per annum with continuous compounding. What is the value of a six-month European put option with a strike price of $50?

3. A stock price is currently $100. Over each of the next two six-month periods it is expected to go up by 10% or down by 10%. The risk-free interest rate is 8% per annum with continuous compounding. What is the value of a one-year European call option with a strike price of $100? 4. (From # 3) What is the value of a one-year European call option with a strike price of $100?

5. A stock price is currently $50. It is known that at the end of two months it will be either $53 or $48. The risk-free interest rate is 10% per annum with continuous compounding. What is the value of a two-month European call option with a strike price of $49? 6. A stock price is currently $80. It is known that at the end of four months it will be either $75 or $85. The risk-free interest rate is 5% per annum with continuous compounding. What is the value of a four-month European put option with a strike price of $80?

7. A stock price is currently $40. It is known that at the end of three months it will be either $45 or $35. The risk-free interest rate with continuous compounding is 8% per annum. What is the value of a three-month European call option and of a European put option with a strike price of $40? 8. A stock price is currently $50. Over each of the next three-month periods it is expected to go up by 6% or down by 5%. The risk-free interest rate is 5% per annum with continuous compounding. What is the value of a six-month European call option with a strike price of $51?

9. (From # 8) What is the value of a six-month European put option with a strike price of $51?

A stock trades for $120. Each year, it will rise by 10% or fall by 20%. The risk-free interest rate is 6% per annum. A call option on this stock has an exercise price of $130. 10. What is the risk-neutral probability of an upward movement in the stock price? 11. What is the delta of this option? (The delta of the option is the change in the option price divided by the change in the price of the underlying security.) 12. What is the price of a European call option that expires in one year? 13. What would the price of the call option be if it expired in two years (not one)? 14. What would be price of the call option be if the strike price were $135 and it expired in one year? 15. The current price of a stock is $50. The stock value either increases by 6% or decreases by 5% every six months. The risk-free rate is 3% per annum with continuous compounding. Determine the value of a one-year European call option with a strike price of $52.

A stock price is now $50. At the end of two months, it will be either $54 or $46. The risk-free interest rate is 9% per annum at all durations. A two month European call option with a strike price of $48 trades on this stock. 16. 17. 18. 19. 20. 21. 22. What is the upward movement in the stock price? What is the downward movement in the stock price? What is the risk-neutral probability of an upward movement in the stock price? If the stock price moves up to $54, what is the value of the call option? If the stock price moves down to $46, what is the value of the call option? What is the expected value of the call option at its maturity in a risk-neutral world? What is the present value of the call option?

A stock price is now $50. At the end of six months, it will be either $60 or $48, with equal probability. The risk-free interest rate is 7% per annum with continuous compounding. 23. What is the expected return on this stock? 24. What is the risk-neutral probability of an upward movement in the stock price? 25. Using a two period binomial tree, what are the three nodes in one year and what are the riskneutral probabilities of reaching each node? 26. If a one year European call option on this stock has a strike price of $60, what is the expected value of this option at expiration in a risk-neutral world? 27. What is the current value of this option? 28. What is the expected value of this option at expiration in the real world? 29. What is the expected return on this option?

A stock price is now $45. During the next six months, it rises 6% or falls 6%. A trader has sold 1,000 six month European call options on this stock with a strike price of $46.

30. 31. 32. 33.

What is the range of the stock price (from low to high) in six months? What is the range of the call option value (from low to high) in six months? What is the delta of the call option? How many shares of the stock must the trader buy to create a riskless hedge?

A stock price will increase by 12% or decrease by 8% over each of the next two years. The risk-free rate of interest is 5% per annum and the stock price is now $60. Options are traded with an exercise price of $70 and a maturity of two years. The stock pays no dividends. 34. 35. 36. 37. 38. 39. What are the two possible stock prices in one year? What are the three possible stock prices in two years? What are the values of the call option at each node in two years? What is the risk-neutral probability of an upward movement in the stock price? What is the risk-neutral probability of getting to each of the three nodes in two years? What is the expected value of the two year European call option at its maturity in a risk-neutral world? 40. What is the current value of the two year European call option?

Answers:
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. $ 1.689 $ 1.1588 $ 9.6092 $ 1.9208 $2.2347 $ 1.7975 $2.85, $2.05 86.67% 5.56% $ 1.64 $ 10.16 $0 $ 3.51 8% 8% 59.06% $6 $0 $ 3.54 $ 3.49 16.6% (annual compounding), 15.36% (continuous) 31.5% $ 72, $ 57.60, $ 46.08 $1.19 $1.11 $ 3.00 170.27% $ 5.40 $ 1.70 0.315 315 shares $ 67.20, $ 55.20 $75.26, $61.82, $50.78 $5.26, $0, $0 65% 42.30%, 45.50%, 12.30% $2.23 $2.02