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FINS3635 - POP QUIZ IN TUTORIAL 9 PROPERTIES OF OPTIONS & THE BINOMIAL MODEL

Instructions
1. This pop quiz is not marked but just for fun. It aims to provide you with some early feedback on your personal understanding of basic option properties and the binomial model. 2. You have 15 minutes to work through the questions. 3. The quiz is open book as it is supposed to test your understanding and not if you have learned all material by heart yet. 4. Each MC question has either one or two correct answers. 5. I will upload the solutions tomorrow (12th of May) on http://www.matthiasthul.com under Teaching FINS3635 S1/2011.

Questions
1) Consider a European call option on a non-dividend-paying stock. Which of the following statements is/are false? (a) The call value can never be negative. This statement is true. Any plain vanilla option has a non-negative payo for the holder of the long position at maturity. It thus follows by no-arbitrage that its current price has to be strictly positive before the maturity date. (b) The intrinsic value can never be negative. This statement is true. The intrinsic value of a plain vanilla option is either zero or strictly positive. (c) The time value can never be negative. This statement is true. If the stock pays no dividends, then the lower bound for the option price is Ct > St Xer(T t) for 0 t < T . Since this is always greater than the intrinsic value of St X, it is never optimal to exercise the European call. 1

(d) It might be optimal to exercise the otherwise identical American option before maturity. This statement is false. As the option price before maturity is strictly greater than its intrinsic value (see (c)), it is never optimal to exercise the otherwise identical American option early. 2) Consider a European put option on a non-dividend-paying stock. Which of the following statements is/are false? (a) The put value can never be negative. This statement is true. See question 1). (b) The intrinsic value can never be negative. This statement is true. See question 1). (c) The time value can never be negative. This statement is false. If the put is deep in-the-money, i.e. the current stock price is signicantly below the strike price, then the time value of the European put might be negative. This is due to the fact that the holder will exercise the option with high probability but only receives the strike payment at a later date. (d) It might be optimal to exercise the otherwise identical American option before maturity. This statement is false. As the time value of the European put option might be negative, it follows that it might be optimal to exercise the American put early. 3) Consider an otherwise identical American and European option. Which of the following statements is/are true? (a) The no-arbitrage price of the American option might be higher than that of the European option. This statement is true. The American option gives its holder all the rights that the holder of the otherwise identical European option has (exercising at maturity). However, it also provides additional rights (exercising before maturity). These rights can never have a negative value but might have a positive value. It thus follows that CtA CtE and PtA PtE for all 0 t T . (b) The no-arbitrage price of the American option might be equal to that of the European option. This statement is true (see (a)). (c) The no-arbitrage price of the American option might be lower than that of the European option. This statement is false (see (a). (d) There is no no-arbitrage relationship between the two options. This statement is false (see (a)). 2

4) Consider a T = 1 year European digital call option that pays o 10 USD if the terminal spot price ST of a non-dividend paying stock is at or above the strike price of X = 100 USD. The current spot price is S0 = 100, the continuously compounded risk-free interest rate is r = 10%. You want to value the option using a n = 2 step binomial tree where the stock goes either up by u = 1.10 or down by d = 0.9 in each step. (a) The risk-neutral probability of an up- and down-move are p = for p. We get p =
erT d ud

,q =

The risk-neutral probability is obtained by solving the equation St ert = (pSt u + (1 p)St d) =
e0.10.5 0.9 1.10.9

= 0.7564 and q = 1 p = 0.2436.

(b) Complete the below tree by rst computing all spot prices Si,j by forward induction and then computing the corresponding option prices Vi,j by backward induction.
S2,2 = 121.00 V2,2 = 10.0000 S1,1 = 110.00 V1,1 = 7.1951 S0,0 = 100.00 V0,0 = 5.1769 S1,0 = 90.00 V1,0 = 0.0000 S2,0 = 81.00 V2,0 = 0.0000 S2,1 = 99.00 V2,1 = 0.0000

(c) The price of the otherwise identical American digital call option is

USD.

Since the initial spot price of S0 = 100 is equal to the strike price of X = 100, the option can be exercised to receive the maximum payo of 10 USD right away. It follows that the current option price must be equal to 10 USD as well. (d) Bonus Question: The price of European digital call option in the Black-Scholes model is given by V0 = . In the Black-Scholes mode, the probability of exercising a European call option at maturity is given by P {ST X} = N (d2 ). Thus, the current option price is V0 = 10erT N (d2 ).