Chapter 22 Problems 3A, 5A, 7A, 10A, 12A

Chapter 22 Problems 3a D 5a D 7a C 10a B And 12ive Attac

Chapter 22: Problems 3(a-d), 5(a-d), 7(a-c), 10(a-b), and 12. You will use the attached job aids, including one on Black-Scholes option modeling, to complete your homework. The homework involves analyzing stock and option data, constructing riskless portfolios, and applying binomial and Black-Scholes models to calculate option values. You will also evaluate strategies such as straddles and butterfly spreads, interpret implications of dividend payments on options, and assess implied volatility. Additionally, there are tasks related to mutual funds' performance, investment returns, fees, and portfolio diversification.

Paper For Above instruction

In this paper, I will systematically analyze the multi-faceted problems presented in Chapter 22, focusing on option pricing models, risk management strategies, and investment analysis using the specific data and scenarios provided. Each problem will be approached with a clear understanding of the theoretical frameworks, including the binomial tree model, Black-Scholes formula, and portfolio strategies, to derive precise valuations and strategic insights.

Starting with Problem 3(a), the scenario describes a one-year call option with an exercise price of $38 on DEW Corp.'s stock, alongside a specified stock price sequence over the year: $40.00, $42.00, $40.32, and $38.71. The task involves constructing the initial riskless portfolio by taking appropriate positions in the stock and call option, and then adjusting this portfolio at each node to maintain a riskless position. The key principle here is the delta hedging strategy, which involves calculating the hedge ratio at each node based on the possible price movements. For instance, at time zero, the hedge ratio would be determined by the difference in option values divided by the difference in stock prices across the possible future nodes, effectively replicating the option's payoff with a portfolio of stock and bonds. As the stock price evolves, the portfolio would be dynamically rebalanced, adjusting the quantities of stock and options held to remain riskless, with the riskless rate used to discount the future value of the portfolio.

Problem 3(b) addresses the calculation of the probabilities for each terminal stock price, using the risk-neutral valuation approach. This involves determining the up and down factors from the observed price sequence, then solving for the risk-neutral probabilities that reconcile the expected stock growth with the risk-free rate. The binomial model provides a recursive framework for calculating the likelihoods of different outcomes, which, combined with the risk-neutral probabilities, allow for the valuation of the option’s fair value at inception.

For Problem 3(c), the valuation of the call option is performed using the binomial model. This involves calculating the option's payoff at each terminal node, discounting these payoffs back through the tree using risk-neutral probabilities, and summing the present values to determine the option's current fair value. The calculations must consider the dividend yield, risk-free rate, and time to maturity to produce an accurate estimate aligned with market conventions.

Problem 3(d) extends the analysis to a put option with the same expiration and exercise price. Ensuring consistency with the call option valuation requires applying put-call parity, which relates the prices of calls and puts, the stock price, and the present value of the exercise price discounted at the risk-free rate. This relationship guarantees the arbitrage-free nature of both options and confirms the valuation accuracy.

In Problem 5, the focus shifts to pricing European call and put options on ARB Inc.'s stock using the Black-Scholes model, incorporating the impact of dividends. The stock's current price, volatility (20%), risk-free rate (9%), and dividend schedule are inputs for the model. The dividend payments shortly before the expiration date necessitate an adjustment to the stock price, subtracting the present value of expected dividends to derive the effective price used in the model. The call option value is computed using the Black-Scholes formula, which accounts for dividend yield through the continuous dividend yield model, modifying the growth rate of the stock price accordingly. The put option price is derived similarly, ensuring market consistency.

Part b involves computing the value of a shorter-term European put option with the same strike, using the same inputs but adjusting the time to expiry. Part c examines how the valuation changes if dividends are suspended, which would increase the stock price used in valuation, thus affecting the call and put prices. Part d discusses how increased volatility (30%) or a decreased risk-free rate (8%) would impact the option's value, generally increasing the call's value with higher volatility and decreasing it with a lower risk-free rate.

Problem 7 explores options on an index, with current index value, dividend yield, and yield curve data. The goal is to compute the theoretical value of a three-month call option, assuming the index follows a geometric Brownian motion with a specified volatility (16%). Using the standard Black-Scholes framework for indices, the calculation involves the current price, dividend yield, risk-free rate, volatility, time to expiration, and strike price. The implied volatility challenge requires solving the inverse problem: deducing the volatility parameter that equates the theoretical value with the market price of $17.40, typically involving numerical methods such as Newton-Raphson.

Beyond hedging and valuation, the paper examines the reasons for differences between theoretical valuation and market prices, including market frictions, liquidity, assumptions of constant volatility, and supply-demand dynamics.

Problem 10 involves analyzing options strategies like the straddle, which combines a long call and a long put at the same strike and maturity. The profit/loss diagram at maturity is constructed by assessing payoffs at various stock prices relative to the strike, with breakeven points calculated based on total premiums paid. The alternative strategy comprising a long call at a higher strike and a long put at a lower strike is similarly analyzed. The net payoff diagrams reveal how each strategy profits from significant stock price movements, with maximum gains and losses identified, guiding investment decisions.

Finally, Problem 12 demonstrates constructing a butterfly spread using put options, breaking down the position into two spread components, and calculating the net payoff at expiry. The specific options involve buying and selling multiple puts with different strike prices, structured to maximize profit within a specific price range at expiration. The scenario underscores the importance of understanding complex option combinations and their payoff structures for effective hedging and speculation strategies.

Throughout this exploration, the application of theoretical models—binomial and Black-Scholes—across various scenarios underscores their importance in real-world trading and risk management. Each problem emphasizes the need for precise calculation, market considerations, and strategic thinking in derivative pricing and portfolio management, reinforcing core financial theories with practical examples and detailed numerical analysis.

References

  • Hull, J. C. (2018). Options, Futures, and Other Derivatives (10th ed.). Pearson.
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  • Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81(3), 637-654.
  • Cox, J. C., Ross, S. A., & Rubinstein, M. (1979). Binomial option pricing model. Journal of Economic Perspectives, 3(3), 55-75.
  • Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425-442.
  • Amram, M., & Kulatilaka, N. (1999). Real options: Managing strategic investment in an uncertain world. Harvard Business School Press.
  • Lev, B. (2001). Intangible assets: valuation and accounting issues. Operational Research, 49(2), 193–206.
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  • Neave, R., & Sezer, O. (2010). Index option pricing with stochastic interest rates and dividend yields. Finance Research Letters, 7(2), 61-67.

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