ESSEN OF INVESTMENTS CONNECT AC
ESSEN OF INVESTMENTS CONNECT AC
11th Edition
ISBN: 9781266650314
Author: Bodie
Publisher: MCG
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Chapter 16, Problem 44C
Summary Introduction

(A)

To Compute:

What will be the payoff to the put, Pu, if the stock goes up?

Introduction:

The payoff to the put, Pu, if the stock goes up is given in the calculation below.

Expert Solution
Check Mark

Explanation of Solution

  Data can be summarized as follows:Exercise price of stock =$110Risk free rate, rt5%Factor by which stock increases (u)=1.1Factor by which stock increases (d)=0.95

Valuation of one year European put option using the two-state approach is described as

follows:

The put price for increase factor of 1.1, S01 is $121 [$110x1.1$121].The put price for

decrease factor of 0.95, S02 is $104.50 [$110×0.95=$104.50].The strike or exercise price is

$110.

Calculate the probable value of put, in case stock price increases ( Pu), as follows

Conclusion

  The put can fall to an expiration-date value of pu1=$0and the put can rise to afinal value of Pu2=$5.50

Summary Introduction

(B)

To Compute:

What will be the payoff, Pdif the stock price falls?

Introduction:

The payoff, Pdif the stock price falls is given using the calculation below.

Expert Solution
Check Mark

Explanation of Solution

The hedge ratio at this point can be calculated by using the following formula:

  H=Pu1Pu2So1So2

Substitute the value to calculate hedge ratio as follows:

  Pu1=$0,Pu2=$5.50,So1=$121,andS02=$104.50H=Pu1Pu2So1So2=$0$5.50$121$104.50=13

Hence, the hedge ratio is 13

The final stock price of the portfolio that will be worth $121 at expiry regardless of the final stock price is as follows:

ESSEN OF INVESTMENTS CONNECT AC, Chapter 16, Problem 44C , additional homework tip  1

The portfolio must have a current market value equal to the present value of 4121 defined by the following equation:

  $110+3Pu=$1211.05Pu=$115.238$1103Pu=$5.2383Pu=$1.746Hence,thevalueofputincasestockincreaseis$1.746

Calculate the value of put in case stock price decreases (Pd)as follows:

The put price for increase factor of 1.1, S03=$90.25The put price for

decrease factor of 0.95, S02=$104.50[$110×0.95=$104.50].The strike or exercise price is

$110

Calculation of the hedge ratio:

The hedge ratio at this point can be calculated by using the following formula:

  Pu1=$5.50,Pu2=$19.75,So2=$104.50,andS03=$90.25H=Pu2Pu3So2So3=$5.50$19.75$104.50$90.25=$14.25$14.25=1.0

Therefore, the hedge ratio is -1.0

The final stock price of the portfolio that will be worth $110 at expiry is as follows:

ESSEN OF INVESTMENTS CONNECT AC, Chapter 16, Problem 44C , additional homework tip  2

The portfolio must have a current market value equal to the present value of $110,which is defined by the following equation:

Hence, the value of put in case stock price decrease is $9.762.

Calculate P using the values of Puand Pd

The put can increase to a value of Pd=$9.762, at this point the stock price is dSo=$95from its

Initial value.

The put can fall to a value of Pu=$1.746, At this point the stock price is uSo=$110from its

Initial value.

Calculate hedge ratio at this point as follows:

H=PuPduSodSo=$1.746$9.762$110$95=$8.016$15=0.5344

Conclusion

Thus, the payoff, Pdif the stock price falls is obtained successfully.

Summary Introduction

(C)

To Compute:

Value the put option using the risk-neutral shortcut described in the box. Confirm that your answer matches the value you get using the two-state approach.

Introduction:

Expert Solution
Check Mark

Explanation of Solution

The portfolio will be worth $60.53 at expiry irrespective of the final stock price as follows:

ESSEN OF INVESTMENTS CONNECT AC, Chapter 16, Problem 44C , additional homework tip  3

The portfolio must have a market value equal to the present value of $60.53 which is defined by the following equation:

$53.44+P=$60.531.05=$57.648$53.44=$4.208

Hence, the value of put option binomial model option pricing is $4.208

Valuation of put option using risk neutral shortcut is described as follows:

Formula for risk neutral probability is as follows:

ρ=1+rfdud

Here,

ρis the probability

rfis the risk free rate

u is factor by which stock increases

d is factor by which stock increases

Calculate the risk neutral probability that the stock price will increase as follows:

ρ=1+rfdud=1+0.050.951.10.95=0.10.15=0.6667

Calculate the expected cash flows at expiration and discount it by the risk free rate to find Pu

and Pdusing the probability as follows:

Calculate Puas follows:

  uE(CF)=0.6667×0+(10.6667)×$5.5=0.6667×0+0.3333×$5.5=$1.8333Pu=E(CF)1+rf=$1.83331+0.05=$1.83331.05=$1.7460

Calculate Pdas follows:

  dE(CF)=0.6667×$5.50+(10.6667)×$19.75=0.6667×$5.50+0.3333×$19.75=$10.25Pd=E(CF)1+rf=$10.251+0.05=$10.251.05=$9.7619

Calculate the expected cash flow in 6 months and discount the E(CF) by the 6 month risk free

Rate as follows:

  E(CF)=0.6667×$1.7460+(10.6667)×$9.7619=0.6667×$1.7460+0.3333×$9.7619=$4.4180P=E(CF)1+rf=$4.41801+0.05=$4.41801.05=$4.208

Hence, the value of put option using risk neutral shortcut is $4.208

Therefore, the value of put option through two state approach and risk neutral shortcut is same, that is, $4.208.

Conclusion

Therefore, the value of put option through two state approach and risk neutral shortcut is same, that is, $4.208.

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