FINANCIAL DERIVATIVES

ASSIGNMENT - 2

Submitted To: Submitted By:

Dr. V.K.Mehta Name – Priyanshu kesarwani

Roll Number- 322/2021

a. What is implied volatility? How can it be calculated?

Answer:
Implied volatility is the level of volatility that would make observed option prices
consistent with the Black-Scholes formula given values for the other parameters.
For example, suppose we are looking at a call on a non-dividend-paying stock.
Let K and T − t denote the call’s strike and time-to-maturity,
and let C be the observed call price. Let St be the stock price
and r the interest rate. Then, the implied volatility is the level
σ for which
Cbs (S, K, T −t, r, σ) = C
where Cbs is the Black-Scholes call option pricing formula.
Implied volatility is always uniquely defined. That is, given an observed call price C,
there is at most one value of σ such that the Black-Scholes formula will give rise to the
observed value C. This is a consequence of the fact that the Black-Scholes price is
increasing in σ. In a general sense, implied volatility represents the market-wide average
perception of volatility anticipated over the option’s lifetime. As such, it is a forward-
looking concept. In contrast, historical volatility is backward looking; it describes the
uncertainty in the stock price evolution that was experienced in the past.

b. “The early exercise of an American put is a trade-off between the time value of
money and the insurance value of a put.” Explain this statement.

Answer:
Options are derivative contracts that give investors(holders) the right to either buy or sell
an underlying asset in the future. The risk of the options is unilateral since only one party
can default.
Unlike European options, American options can be exercised at any time during the
contract period and at expiration.
When an investor goes long an American put and long the underlying asset, he creates a
risk-free portfolio (insured portfolio) since there is no risk of loss due to price changes. If
the put option is exercised before expiration, the insurance aspect ceases. The investor
then invests the money to earn a return for the remaining period of the contract, therefore
the trade off
c. Why an American call option on a dividend-paying stock is always worth at least as
much as its intrinsic value. Is the same true of a European call option? Explain
your answer.

Answer:
An American call option can be exercised at any time. If it is exercised its holder gets the
intrinsic value. It follows that an American call option must be worth at least its intrinsic
value. A European call option can be worth less than its intrinsic value. Consider, for
example, the situation where a stock is expected to provide a very high dividend during
the life of an option. The price of the stock will decline as a result of the dividend.
Because the European option can be exercised only after the dividend has been paid, its
value may be less than the intrinsic value today.

d. Explain why the arguments leading to put–call parity for European options cannot
be used to give a similar result for American options.

Answer:
When early exercise is not possible, we can argue that two portfolios that are worth the
same at time must be worth the same at earlier times. When early exercise is possible,

the argument falls down. Suppose that . This situation does not lead to
an arbitrage opportunity. If we buy the call, short the put, and short the stock, we cannot
be sure of the result because we do not know when the put will be exercised.

e. Show that a European call option on a currency has the same price as the
corresponding European put option on the currency when the forward price equals
the strike price.

Answer:
This follows from put–call parity and the relationship between the forward price,
F0 and the spot price, S0

and,
so that,

If, K = S0 this reduces to c = p. The result that c = p when K = F 0 is true for options on all
underlying assets, not just options on currencies. An at-the-money option is sometimes
defined as one where K = F0 (or c = p) rather than one where K = S0.

f. Show that the probability that a European call option will be exercised in a risk-

neutral world is .

Answer:
The probability that the call option will be exercised is the probability that where

is the stock price at time . In a risk neutral world, the probability distribution of
ln ST is,
φ { ln S 0 +(r−σ 2 / 2 )T , σ 2 T }

The probability that ST > K is the same as the probability that ln ST > ln K. This is

g. Does a forward contract on a stock index have the same delta as the corresponding
futures contract? Explain your answer.

Answer:
With our usual notation the value of a forward contract on the asset is S0e-qT – Ke-rT. When

there is a small change, , in S0 the value of the forward contract changes by .

The delta of the forward contract is therefore . The futures price is S0e (r -q) T When

there is a small change, , in S0 the futures price changes by . Given the daily
settlement procedures in futures contracts, this is also the immediate change in the wealth
of the holder of the futures contract. The delta of the futures contract is therefore e (r – q) T
We conclude that the deltas of a futures and forward contract are not the same. The delta
of the futures is greater than the delta of the corresponding forward by a factor of e rT.

h. What is meant by the gamma of an option position? What are the risks in the
situation where the gamma of a position is large and negative and the delta is zero?

Answer:
The gamma of an option position is the rate of change of the delta of the position with
respect to the asset price. For example, a gamma of 0 would indicate that when the asset
price increases by a certain small amount delta increases by 0 of this amount. When the
gamma of an option writer’s position is large and negative and the delta is zero, the
option writer will lose significant amounts of money if there is a large movement (either
an increase or a decrease) in the asset price.

i. If the delta of a European call is 0.6, what is the delta of the European put for the
same strike and maturity?

Answer:
Start with put-call parity:
C − P = S − PV (K)
which leads to
∆C − ∆P= 1
Hence,
∆P = ∆C − 1 = 0.6 − 1 = (−0.4)

j. You had a portfolio that is short 2,000 puts, each with a delta of -0.63. What would
you do to delta-hedge the portfolio?

Answer:
We would sell 2000 × 0.63 = 1260 shares of the stock. Since the delta of a put is negative,
a long put would be hedged by buying stock. The converse, a short position in puts would
be hedged by selling stock
k. The theta of a put with 23 days left to maturity is -17.50. Other things being equal,
by how much does the value of the put changes if a day passes?

Answer:
Assuming that the change of one day is denoted as ∆t = 1/365,
then the value of the put decreases by
∆P = −17.50 × ∆t = −0.0479

l. Traded options formulas are derived by solving Partial Differential Equation

(PDE) subject to boundary conditions. Write down the PDE and state key boundary
conditions in case of a European call option.

Answer:
As per the PDE approach the call option value is the solution to the following differential
equation:

For the European call option’s payoff, the three boundary conditions are:

m. Show that the price of a European call with lower exercise price (X1) cannot be
less than that of the call with higher exercise price (X2). (Hint: Assume an initial
portfolio A with a long position in call with lower exercise price of X1 and short
position in call with higher exercise price of X2.)

Answer:

n. How does the put-call parity formula for a futures option differ from put-call parity
formula for an option on a non-dividend paying stock?

Answer:
The basic difference between put–call parity relationship for futures option and the one
for a non-dividend-paying stock in equation is that the stock price, S 0, is replaced by the
discounted futures price, F0e-rT

Put–call parity relationship for futures option

Portfolio A: a European call futures option plus an amount of cash equal to KerT

Portfolio B: a European put futures option plus a long futures contract plus an amount of
cash equal to F0e-rT, where F0 is the futures price

Because the two portfolios have the same value at time T and European options cannot be
exercised early, it follows that they are worth the same today.
The value of portfolio A today is
C+ Ke-rT
where C is the price of the call futures option.

The daily settlement process ensures that the futures contract in portfolio B is worth zero
today. Portfolio B is therefore worth
P+ F0 e-rT
where p is the price of the put futures option.
Hence, C+ Ke-rT = P+ F0 e-rT

Put–call parity relationship for non-dividend paying stock

Portfolio A: one European call option plus a zero-coupon bond that provides a payoff of
K at time T

Portfolio B: one European put option plus one share of the stock.

We assume that the stock pays no dividends. The call and put options have the same
strike price K and the same time to maturity T

The components of portfolio A are worth c and Ke -rT today, and the components of
portfolio B are worth p and S0 today.

Hence, as per put-call parity C+ Ke-rT = P+ S0