Chap13 supplement 2

Problem 13.29.
Calculate the value of nine-month American call option on a foreign currency using a
three-step binomial tree. The current exchange rate is 0.79 and the strike price is 0.80
(both expressed as dollars per unit of the foreign currency). The volatility of the
exchange rate is 12% per annum. The domestic and foreign risk-free rates are 2%
and 5%, respectively. Suppose a company has bought options on 1 million units of the
foreign currency. What position in the foreign currency is initially necessary to hedge its
risk?

The tree is shown in Figure S13.13. The cost of an American option to buy one million units of
the foreign currency is $23,952. The delta initially is (0.047551 −0.006875)/(0.83885 – 0.74399)
= 0.4288. The company should sell 428,800 units of the foreign currency

0.945802
0.145802
0.890723
0.090723
0.838851 0.838851
0.047551 0.038851
0.79 0.79
0.023952 0.016343
0.743994 0.743994
0.006875 0
0.700667
0
0.659863
0

Figure S13.13: Tree for Problem 13.29

1
Problem 13.28.
A stock index is currently 990, the risk-free rate is 5%, and the dividend yield on the
index is 2%. Use a three-step tree to value an 18-month American put option with a
strike price of 1,000 when the volatility is 20% per annum. How much does the option
holder gain by being able to exercise early? When is the gain made?

The tree is shown in Figure S13.12. The value of the option is 87.51. It is optimal to exercise at
the lowest node at time one year. If early exercise were not possible the value at this node would
be 236.63. The gain made at the one year point is therefore 253.90 – 236.63
= 17.27.

1513.18
0.00
1313.63
0.00
1140.39 1140.39
31.07 0.00
990.00 990.00
87.51 66.08
859.44 859.44
152.75 140.56
746.10
253.90
647.71
352.29

Figure 13.12: Tree for Problem 13.28

2
Problem 13.18.
The futures price of a commodity is $90. Use a three-step tree to value (a) a nine-month
American call option with strike price $93 and (b) a nine-month American put option
with strike price $93. The volatility is 28% and the risk-free rate (all maturities) is 3%
with continuous compounding.

u=e0 . 28× √0 .25=1 .1503

The tree for valuing the call is in Figure S13.7a and that for valuing the put is in Figure S13.7b.
The values are 7.94 and 10.88, respectively.
136.98 136.98
43.98 0.00
119.08 119.08
26.08 0.00
103.52 103.52 103.52 103.52
14.62 10.52 4.16 0.00
90.00 90.00 90.00 90.00
7.94 4.86 10.88 7.84
78.24 78.24 78.24 78.24
2.24 0.00 16.88 14.76
68.02 68.02
0.00 24.98
59.13 59.13
0.00 33.87

Figure S13.7a: Call Figure S13.7b: Put

3
Problem 13.25.
Consider a European call option on a non-dividend-paying stock where the stock price is $40,
the strike price is $40, the risk-free rate is 4% per annum, the volatility is 30% per annum, and
the time to maturity is six months.
a. Calculate , , and for a two step tree
b. Value the option using a two step tree.
c. Verify that DerivaGem gives the same answer
d. Use DerivaGem to value the option with 5, 50, 100, and 500 time steps.

(a) This problem is based on the material in Section 13.8. In this case so that
, , and

(b) and (c) The value of the option using a two-step tree as given by DerivaGem is shown in
Figure S13.11 to be 3.3739. To use DerivaGem choose the first worksheet, select Equity as the
underlying type, and select Binomial European as the Option Type. After carrying out
thecalculations select Display Tree.
(d) With 5, 50, 100, and 500 time steps the value of the option is 3.9229, 3.7394, 3.7478, and
3.7545, respectively.

At each node:
Upper value = Underlying Asset Price
Lower value = Option Price
Values in red are a result of early exercise.

Strike price = 40
Discount factor per step = 0.9900
Time step, dt = 0.2500 years, 91.25 days
Growth factor per step, a = 1.0101
Probability of up move, p = 0.4959
Up step size, u = 1.1618
Down step size, d = 0.8607
53.99435
13.99435
46.47337
6.871376
40 40
3.373919 0
34.42832
0
29.63273
0
Node Time:
0.0000 0.2500 0.5000

Figure S13.11: Tree produced by DerivaGem to evaluate European option in Problem 13.25

4
5