STAT 473.

Spring 2015
Practice Problems for Final Figueroa-López

Description:

(A) The problems below are only intended to serve as preparation or practice for your actual
final exam. The solution key of the exam is provided at the end of the document.

(B) You should not expect that your actual exam will cover only the topics or skills reviewed
in this problem set nor that your actual exam will be of the same length as this problem
set.

(B) Any material seen in class (including conceptual material) could potentially be tested in
your actual final exam and, thus, you are expected to thoroughly review your class notes.
1. Assume the Black-Scholes framework holds. Consider a stock, a European call, and a
European put on the stock. You are given:

(i) The current stock price, call price, and put price are 45.00, 4.45, and 1.90, respec-
tively.
(ii) Investor A purchase two calls and one put.
(iii) Investor B purchase two calls and writes three puts.
(iv) The current elasticity of Investor A’s portfolio is 5.0.
(iv) The current delta of Investor B’s portfolio is 3.4.

If the stock price increases by one percentage point, then we expect the put premium to
decrease by

(A) 0.55 %
(B) 1.15 %
(C) 8.64 %
(D) 13.03 %
(E) 27.24 %
2. Given the following information regarding a European call and a European put with the
same strike price, and same time to expiry, on a stock that does not pay dividends, find
the call price.

Call option Put option

Elasticity 18 -6
.
Option price 7.5
Delta -0.46
3. Several months ago, an investor sold a one-year European call option on 100 shares of a
non-dividend-paying stock. She immediately hedge the commitment by investing in the
replicating portfolio of the call option, but has not ever re-balanced her portfolio. She
now decides to close out all positions.
You are given the following information:

(i) The risk-free interest rate is constant

(ii)
Several moths ago Now
Stock Price $ 40.00 $ 50.00
Call option price $ 8.88 $ 14.42
Put option price $ 1.63 $ 0.26
Call option delta 0.794
The put option in the table above is a European option on the same stock and with
the same strike price and expiration as the call option

Calculate her profit/loss now.

(A) $ 11
(B) $ 24
(C) $ 126
(D) $ 217
(E) $ 240
4. Assume the Black-Scholes framework. Eight months ago, an investor borrowed money
at the risk-free interest rate to purchase a one-year 75-strike European call option on a
nondividend-paying stock. At that time, the price of the call option was 8.
Today, the stock price is 85. The investor decides to close out all positions.
You are given:

(i) The continuously compounded risk-free rate interest rate is 5%.

(ii) The stocks volatility is 26%.

Calculate the eight-month holding profit.

(A) 4.06
(B) 4.20
(C) 4.27
(D) 4.33
(E) 4.47
5. You are given the following information for European put options on a stock:

Strike Price 40 50 60
Option premium 2.00 5.00 12.00
Option Delta -0.8 -0.4 -0.1

The price of the underlying is 48. A butterfly spread consists of buying a 40-strike and a
60-strike put (one of each) and selling two 50-strike put options.

(a) If you own the butterfly spread of part (a), how many shares of the asset do you
need to buy or sell at time 0 in order to delta-hedge your position?
(b) Suppose that after you delta-hedge your position at time 0, you won’t rebalance your
portfolio for one-month. If you then decide to close all your positions (after one-
month), compute your marking-to-market profit/loss assuming that the new price
of the underlying is 50 and the new premiums of the options are as follows:
Strike Price 40 50 60
Option premium 1.8 4.00 10.00
The risk-free interest rate is 5%.
6. An investor bought a European call option on a stock and delta-hedged with the stock.
Later on, but before expiry of the option, she closed the position:
Your are give:

(i) The stock was worth 40 when the call was bought and 50 when it was sold.
(ii) The call was worth 4.25 when it was bought and 9.30 when it was sold.
(iii) A European put option with the same strike price and expiry was worth 8.50 when
the call option was bought and 5.30 when it was sold.
(iv) ∆ was 0.3 when the call option was bought.
(v) The stock pays no dividend.

Determine the amount of profit, including interest, that the investor made.
7. You are given: S0 = 100, K = 95, r = 8%, δ = 0, σ = 30%, and T = 1. Further, you are
given that:

Call Price Delta Gamma Theta (expressed per day)

18.3871 0.7216 0.0112 -0.0256

Assume that a market maker sell 50 calls. If the price of the stock changes from 100 to
101 during the first day after the calls were sold. Estimate the price of the 50 calls using:

a. Delta Approximation
b. Delta-Gamma Approximation
c. Delta-Gamma-Theta Approximation
8. Write the correct answer on the right-hand side:

(A) Cov(Z(2), Z(3)) =

Z t
(B) Z(s)dZ(s) =
0

(C) E(Z(t)2 ) =
(D) P (Z(9) ≥ 9) =
(E) If X(t) is a martingale, then E(X(t)) = for any t.
(F) Var(Zt |Zs ) = .
9. Let {Zt } be a standard Brownian Motion. You are given the following processes:
Z t
2
(i) U (t) = Zt − 3 Zu du;
0
Zt − 2t
(ii) V (t) = e ;

Which of the processes defined above are martingales?

10. Let x(t) be the dollar/euro exchange rate at time t. That is, at time t, 1 Euro costs x(t)
dollars. Let the constant r be the dollar-denominated continuously compounded risk-free
interest rate. Let the constant re be the euro-denominated continuously compounded
risk-free interest rate. You are given

dx(t)
= (r − re )dt + σdZ(t),
x(t)

where Z(t) is a standard Brownian motion and σ is a constant. Let y(t) = 1/x(t) be the
euro/dollar exchange rate at time t. Which of the following equation is true?

(A) dy(t)/y(t) = (re − r)dt + σdZ(t)

(B) dy(t)/y(t) = (re − r − σ 2 /2)dt + σdZ(t)
(C) dy(t)/y(t) = (re + r − σ 2 /2)dt + σdZ(t)
(D) dy(t)/y(t) = (re − r + σ 2 )dt − σdZ(t)
(E) None of the above
11. You are given the following Itô processes

dX(t) = Z(t)dZ(t)
Y (t) = te−2X(t) ,

where as usual Z(t) is a Brownian motion. The process Y (t) can be written as

dY (t)
= a(t, Z(t))dt + b(t, Z(t))dZ(t),
Y (t)

for some functions a(t, z) and b(t, z). Find a(2, 1/2) and b(2, 1/2).
12. Consider a non-dividend paying stock whose prices process follows the Geometric Brow-
nian motion with the following specifications:

• The current stock price is 100.

• The continuously compounded expected rate of return on the stock is 10%
• The stock volatility is 30%

(i) The stock prices process S(t) can be written as aebZ(t)+ct for some constants a, b,
and c. Determine the values of these constants.
(ii) The stock prices process S(t) can be written as dS(t) = a(S(t))dt + β(S(t))dZ(t) for
some functions a(x) and β(x). Determine precise expressions for a(x) and β(x).
(iii) Let
Y (t) = S(t)2 .
You are given that
dY (t) = γ(Y (t))dt + η(Y (t))dZ(t).
for some functions γ(y) and η(y). Find the values of γ(1) and η(1).
13. The price of a stock at time t is denoted by S(t). The stock does not pay dividends.
The price at time t of a European contingent claim written on the stock is D(t) =
F (t, S(t)) for a function F (t, s).
Your are given the values of the following claim’s greeks today:

∆ = 0.5, Γ = 0.05, θ = 0.1.

(a) Assuming that S(t) follows an arithmetic Brownian motion with parameters m = 0.5
and σ = 0.40, determine the drift and noise terms of D(t) today.
(b) Assume instead that S(t) follows a geometric Brownian motion with volatility σ =
0.40 and spot price S(0) = 10, and the risk-free rate of return is r = 0.05. Compute
the premium of the option.
14. The time-t price of a stock is S(t). You are given:

(a) S(t) satisfies the Black-Scholes framework.

 
S(t)
(b) Var ln = 0.01t.
S(0)
(c) The stock pays continuous dividend at the rate of 0.06 per year.
(d) The continuously compounded risk-free rate is 0.03.

A derivative security has price F (t, S(t)) = S(t)a e0.08t at time t. The derivative does not
pay any dividends. Determine all the values of a.
15. Consider a 3-month European call option on a stock. You are given:

(a) The stock’s price follows the Itô process:

dS(t)
= 0.16dt + 0.40dZ(t).
S(t)

(b) The call’s price C(t, S(t)) follows the Itô process:

dC(t, S(t))
= γdt + σC dZ(t)
C(t, S(t))

(c) C(0) = 4.00.

(d) The cost of shares of stock required to delta-hedge the option is 14.00.
(e) r = 0.06 and δ = 0.02.

Determine γ.
16. For two nondividend paying stocks, you are given the following Itô processes:

dS1 (t) dS2 (t)

= 0.07 dt + 0.3 dZ(t), = 0.04 dt − σ dZ(t).
S1 (t) S2 (t)

In addition, S1 (0) = 40, S2 (0) = 60, and r = 0.05.

A risk-free portfolio requiring no cash outlay consists of 100 shares of the stock with price
S1 (t), x shares of the stock with price S2 (t), and a 1-year bond with face value K earning
the risk-free rate.
Determine x.
17. You are given:

(a) The time-t price of a stock is S(t).

(b) S(t) follows geometric Brownian motion.
(c) C(t, S(t)) = ert ln S(t) is the price of a claim on the stock.
(d) The continuously compounded risk-free interest rate is 0.05.
(e) Var(ln S(t)|S(0)) = 0.09t.

Determine the continuously compounded dividend rate of the stock.

18. Your company has just written one million units of a one-year European asset-or-nothing
put option on an equity index fund. The option’s payoff at maturity is given by the value
of the index fund at maturity if the equity index fund is down by more than 40% at the
end of one year. Otherwise, the option’s payoff is 0.
The equity index fund is currently trading at 1000. It pays dividends continuously at a
rate proportional to its price; the dividend yield is 2%. It has a volatility of 20%. The
continuously compounded risk-free interest rate is 2.5%
Using the Black-Scholes model, determine the price of the asset-or-nothing put options.
19. For a stock whose price at time t is St , you are given:

(i) The stock’s price follows the Black-Scholes framework.

(ii) S0 = 50.
(iii) δ = 0.02.
(iv) σ = 0.1.
(v) r = 0.03.

An option will pay, at the end of 1 year,

(i) 30 if S1 ≤ 50;
(ii) 20 if 50 < S1 ≤ 60;
(iv) 0 if S1 > 60.

Determine the price of the option.

20. For a nondividend paying stock whose price follows the Black-Scholes framework, let St
be the price at time t. You are given:

(i) S0 = 60.
(ii) Var(ln St /S0 ) = 0.25t
(iii) r = 0.07.

You are offered a payment of 70 − S2 at time 2 if the stock price is less than 60 at that
point. In return, you will pay x at time 1 if S1 > 60, 0 otherwise.
Determine x to make this a “fair” deal (that is, the prepaid forward price of this deal at
time 0 should be 0).
Solution Key:

1. (D)

2. 2.9347.

3. (B)

4. (A)

5. (a) Buy 0.1 shares of the underlying stock. (b) −0.0367 (a loss of 0.0367 dollars).

6. 2.35

7. (a) 19.1087 × 50; (b) 19.1143 × 50; (c) 19.0887 × 50.

Zt2 t
8. (A) 2, (B) (corrected) − , (C) t, (D) 1 − N (3), (E) X0 , (F) t − s.
2 2
9. Only (ii) is a martingale (corrected).

10. (D)

11. a(2, 1/2) = 1 and b(2, 1/2) = −1.

12. (i) a = 100, b = 0.3, and c = 0.055; (ii) a(x) = 0.1x and β(x) = 0.3x; (iii) γ(1) = 0.29
and η(1) = 0.6.

13. (a) Drift = 0.354 Noise = 0.2. (b) Premium = 15.

14. a = 2 or a = 5.

15. γ = 0.48.

16. x = 400/3

17. 0.005.

18. 3.6267 × 1, 000, 000.

19. 23.299

20. 38.99