Assignment 5 Options 1: European Put And Call ✓ Solved

Assignment5options1 A European Put Option And A European Call Optio

Analyze several option pricing scenarios including European options, synthetic options, and risk management strategies. The tasks involve calculating the annual interest rate based on given option prices, determining the fair value of a European put option under binomial assumptions, designing hedging strategies with options to prevent bankruptcy, valuing corporate debt and equity using risk-neutral valuation, and calculating and comparing prices of American options with different payoffs and behaviors.

Specifically, the assignment covers: calculating the implied interest rate from given European option prices; valuing a European put option with binomial assumptions and constructing a synthetic put; evaluating risk-management strategies involving options for a company exposed to gold price fluctuations; determining the value of corporate debt and equity based on possible future asset values and risk-neutral probabilities; and analyzing American put and call options, including option pricing in binomial models, and examining put-call parity for American options.

Sample Paper For Above instruction

The analysis of option pricing and risk management involves multiple facets of financial derivatives and their valuation techniques. This comprehensive study addresses various scenarios reflective of real-world financial phenomena, ranging from fundamental European option pricing to complex corporate risk mitigation strategies and American option valuation.

Part 1: Implied Interest Rate from European Options

The first problem considers a European put and call option with exercise price $45, expiring in two months, priced at $2.65 and $5.32 respectively. The current stock price is $47.30. To find the annual continuously compounded risk-free rate, we employ the put-call parity relationship for European options:

\[ C - P = S_0 - Ke^{-rT} \]

Where \( C \) is the call price, \( P \) the put price, \( S_0 \) the current stock price, \( K \) the strike price, \( r \) the annual risk-free rate, and \( T \) the time to expiration in years. Substituting the known values:

\[ 5.32 - 2.65 = 47.30 - 45e^{-r \times \frac{2}{12}} \]

Calculating the difference on the left side:

\[ 2.67 = 47.30 - 45e^{-r \times \frac{1}{6}} \]

Rearranged to solve for \( r \):

\[ 45e^{-r/6} = 47.30 - 2.67 = 44.63 \]

\[ e^{-r/6} = \frac{44.63}{45} \approx 0.9914 \]

\[ -\frac{r}{6} = \ln(0.9914) \approx -0.0086 \]

\[ r \approx 0.0086 \times 6 = 0.0516 \text{ or } 5.16\% \]

This corresponds to a continuously compounded annual interest rate of approximately 5.16%.

Part 2: Valuing a European Put Option and Constructing a Synthetic

Rob desires to purchase a six-month European put option with strike \( K = \$40 \). The stock price can rise to \$60 or fall to \$15. The current stock price is \$30. The risk-free rate is 8% annually, compounded effectively. Using the binomial model, the risk-neutral probability \( p \) is calculated as:

\[ p = \frac{(1 + r)^{T} - d}{u - d} \]

Where \( u = \frac{60}{30} = 2 \), \( d = \frac{15}{30} = 0.5 \), and \( r = 0.08 \). The risk-neutral probability is:

\[ p = \frac{(1 + 0.08)^{0.5} - 0.5}{2 - 0.5} \]

Calculating \( (1 + 0.08)^{0.5} \approx 1.0392 \), so:

\[ p = \frac{1.0392 - 0.5}{1.5} \approx \frac{0.5392}{1.5} \approx 0.3595 \]

The expected payoff of the put now is:

- If the stock falls to \$15, payoff = \( \max(0, 40 - 15) = 25 \).

- If the stock rises to \$60, payoff = \( \max(0, 40 - 60) = 0 \).

Expected value of the put:

\[ PV = \frac{p \times 25 + (1 - p) \times 0}{(1 + r)^{0.5}} \]

With \( p = 0.3595 \) and discount factor \( (1 + 0.08)^{0.5} \approx 1.0392 \):

\[ PV = \frac{0.3595 \times 25}{1.0392} \approx \frac{8.9875}{1.0392} \approx 8.65 \]

Thus, the fair value of the put today is approximately \$8.65.

To create a synthetic put, one can replicate its payoff by buying a stock and financing with borrowed funds, combined with other options. Specifically, it involves shorting a stock equivalent to the strike price and taking positions in call options, which is complex but theoretically feasible. The cost of the synthetic put can be derived from the sum of these positions, and it should approximately match the directly computed fair value, affirming no arbitrage.

Part 3: Managing Risk for Maverick Manufacturing

Maverick faces the risk of gold prices rising above \$875 per ounce, which could bankrupt the firm. As such, purchasing a call option with a strike price near \$875 is optimal. Given the current gold price at \$815 and possible future prices at \$975 or \$740, the company should consider buying a call with strike \$875, expiring in three months, to hedge against the scenario where gold prices climb above the bankruptcy threshold.

The expected payoff at expiration:

• If gold rises to \$975, payoff = \( 975 - 875 = 100 \)
• If gold falls to \$740, payoff = 0

Risk-neutral probability \(\tilde{p}\) is calculated as:

\[ \tilde{p} = \frac{(1 + r)^{T} - d}{u - d} \]

Where \( u = \frac{975}{815} \approx 1.196 \), \( d = \frac{740}{815} \approx 0.909 \), \( r=6.50\%. \) The within three months effective rate is used for discounting, but for simplicity, approximation yields similar results to previous calculations. The cost of such an option is computed via standard binomial valuation, and this cost represents the minimal premium to hedge against bankruptcy risk effectively.

Such an option's fair price is determined through standard binomial methods, considering the risk-neutral probabilities, up and down factors, and the chosen strike. Real-world prices would range around \$20–\$30, depending on market conditions and implied volatility.

Part 4: Corporate Debt and Equity Valuation

The company's asset value today is \$20. Tomorrow, the asset will be either worth \$24 or \$16 with equal probability, and it owes \$18 in debt next period. Using risk-neutral valuation, the probability \( p \) of the good state (asset value = 24) is:

\[ p = \frac{(1 + r) - d}{u - d} \]

with \( u=24 \), \( d=16 \), and risk-free rate \( r=10\%. \) Calculating the present value of debt: the expected payoff, discounted at \( r \), is:

\[ D = \frac{p \times 18 + (1 - p) \times 18}{(1 + r)} = 18 \]

since the debt payoff is fixed at 18, the debt value is \$18. The expected yield compares with the risk-free rate, but the actual yield depends on the probability-weighted returns. The company's equity value equals the residual value of the firm's assets after debt repayment, which is either \( 24 - 18=6 \) in the good state or \( 16 - 18=0 \) in the bad state. The expected equity value is:

\[ \text{Expected equity} = p \times 6 + (1 - p) \times 0 \]

which, after discounting, provides current equity valuation. The existence of a government loan guarantee increases the firm's value by removing bankruptcy risk, effectively reducing the expected loss in bad states and increasing current valuation.

Part 5: American Options Pricing and Put-Call Parity

The American put with strike 50, expiring in two years, involves binomial modeling. The stock price follows a two-period binomial process, with equal probability for up and down movements. The value of the option is determined through backward induction, considering early exercise possibilities. The presence of dividends or other factors can influence the value, but with no dividends, the approximate value is based on expected payoffs discounted at the risk-free rate. Similarly, an American call on the same stock with identical parameters often exceeds the European counterpart due to early exercise features, especially if dividends are involved. For the put-call parity, in European options, it holds as:

\[ C - P = S_0 - K e^{-rT} \]

However, for American options, early exercise possibilities invalidate this parity under certain conditions, unless the options are on non-dividend-paying stocks and do not have early exercise premiums.

In conclusion, the valuation of complex derivatives and risk management strategies involves integrating pricing models, probability assessments, and market data to make informed decisions that mitigate risk and optimize financial outcomes. These analyses exemplify the critical role of quantitative methods in modern financial engineering.

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