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ECMT3150: Assignment
NOTE: Please do not write your
nal answers in your R-script. You should summarise the
outputs (e.g., plots) and include your discussion and
nal answers in the written response
le. Both your written response
le and R-script (i.e., the .R source
le, not the screenshot)
need to be submitted.
[Total: 30 marks (+ bonus)] Bob is a budding investment banker in the pricing team.
He proposes the following toy model for a single-period market that consists of a risk-free
money account and the stock CBA. The time length of the period is . Let S0 denote the
price of a share of CBA at time 0. At the end of the period (time ), its price either goes
up to S = S0u or down to S = S0d. Let q denote the probability that the share price
goes up under the risk-neutral probability measure Q. The risk-free interest rate is r. Let
a = er.
1. [2 marks] Write down the risk-neutral probability distribution of S, the share price
at time . Express the probability mass function in terms of u; d and q.
2. [3 marks] Show that q = ad
ud . [Hint: the discounted share price is a martingale under
Q.]
3. [3 marks] Find V ar(S), the variance of the share price at time ? Express your
answer in terms of a, u and d.
4. [3 marks] Let u = e
p
and d = 1
u
= e
p
. Show that V ar(S) S202 for small
. [Hint: ex 1 + x if x is close to zero. The
nal result is obtained by dropping
terms involving higher power of ]
Now Bob wants to build a binomial tree model for the share price of CBA stock traded
in an n-period market, where n is a positive integer. The binomial tree model is given as
follows. In period i (i = 1; : : : ; n), the CBA share price starts at S(i1), and it either goes
up to S(i1)u with Q-probability q, or goes down to S(i1)d with Q-probability 1 q. The
probability q is as given in question 2, and u and d are as given in question 4 (i.e. u = e
p
and d = 1
u
= e
p
). Assume that the price changes are independent across all n periods.
5. [3 marks] Let j denote the number of times by which CBA goes up over n periods.
What is the probability distribution of j? For a given j, show that the CBA share
price at the end of period n is given by
Sn = S0u
jdnj:
1
6. [2 marks] Consider a European call option written on a share of CBA stock at time 0
with strike price X and time-to-maturity = n. Show that its price is given by
Cbin0 = E
Q[ernmax(Sn X; 0)]: (1)
Suppose we are at time 0, and the current CBA share price is S0 = 100. Suppose r = 0:01
and = 0:4. Write an R code that simulates 1000 sample paths of CBA share price using
the above binomial tree model with the following speci
cations: n = 21, = 1=252.1 While
simulating the random numbers, set the random seed to be the last 5 digits of your SID.2
[Hint: you may use rbinom(1000,n,p)to generate 1000 random integers from a binomial
distribution with parameters n and p.]
7. [3 marks] Using your code, compute the time-0 price of an at-the-money European call
option written on a share of CBA stock at time 0 with strike price X = S0 = 100 and
expiring in 21 days (i.e., = 21).
8. [3 marks] Compute analytically the time-0 price of the same call option using the
Black-Scholes formula instead. Compare it with your answer in question 7.
Bob has recently moved to the product design team. He is currently designing an exotic
option written on a share of CBA stock at time 0. This option will give the following payo¤
as a function of the share price S at time
g(S ) =
8<:
X1 S for S < X1;
0 for X1 S X2;
S X2 for S > X2;
where X1 < X2. Bob named this exotic option as y-with-Bob,after noting that the graph
of the payo¤ function looks like the wings of an aeroplane.
9. [3 marks] Using your code, compute the time-0 price of a y-with-Bob option with
strike prices X1 = 90, X2 = 110 and expiring in 21 days (i.e., = 21).
10. [3 marks] Compute analytically the time-0 price of a y-with-Bob option using the
Black-Scholes formula instead. Compare it with your answer in question 9.
11. [2 marks] What type of investors will be interested in y-with-Bob?
12. [Optional question for those who are up to the challenge; bonus marks will be given for
correct solutions] Prove mathematically that Cbin0 as de
ned in question 6 converges to
the Black-Scholes call price as ! 0 and n!1 while = n remaining constant.
1The time step = 1252 , measured in years, is equivalent in length to a day out of 252 trading days in a
year. The total length of n time steps, n = 112 , therefore amounts to a month measured in years.
2This is to ensure that your answer will be di¤erent from that of other students.