binomial option pricing model , Risk Management

Question 1

Zero coupon yields (all yields are continuously compounded) are 3.00% for three months, 3.50% for six months, 3.60% for nine months and 3.80% for twelve months. NorthBank is contemplating 'buying' a one-year plain vanilla interest rate swap involving the quarterly exchange of fixed and floating interest rate payments on a notional principal of $200 million. Note: a swap buyer pays fixed, receives floating.

(a) Use the portfolio of bonds approach to calculate the 'fair' swap rate.

(b) Assume that NorthBank 'buys' the swap at the 'fair' swap rate determined in (a) above. However, within minutes of entering the swap, the zero coupon yield curve falls by 10 basis points. Calculate the value of the swap to NorthBank.

Question 2

A non-dividend paying stock price is currently $8.00. It is known that at the end of three months it will be either $4.00 or $11.00. The risk free rate of interest with continuous compounding is 25% p.a.. Calculate the value of a European put option with an exercise price of $10.00.

Verify that the value of the put option is the same under:

(a) the no arbitrage valuation method (i.e. a portfolio comprising a short or long position in delta shares and one option); and

(b) the risk-neutral valuation method (based on the probability of upward and downward stock price movements).

Question 3

A European put option on a dividend-paying stock is selling for $2.15. The underlying stock price is $21, the exercise price is $24, a dividend of $0.20 is expected in two months and the option expires in six months. The risk free rate is 6% p.a. continuously compounded (all maturities).


Show how an arbitrageur can exploit this situation. You can assume the arbitrageur can borrow or lend at the risk free rate, incurs no transactions costs and can short-sell the stock if necessary. Ensure that the net cash flow at time 0 is positive.

Question 4

In December 2009 an options trader bought a March 2010 $40 put on Bayco stock for $2.50 and sold one June 2010 $40 put on Bayco stock for $3.30 (i.e., the exercise price for both options is $40).


Draw a profit and loss diagram in Excel of the trader's portfolio at the expiration date of the March 2010 put option. The diagram should show the outcome for a range of stock prices between $30 and $50 in increments of $1. Ignore any transaction costs incurred to create the portfolio other than the initial cost of buying or selling the options.

You should use the Black Scholes model to price the June 2010 option that remains alive in March 2010. To value this option assume the remaining time to maturity of the option is 3 months, Bayco's annual volatility is 25% and the continuously compounded risk free rate is 6% p.a. The stock does not pay dividends.

Question 5

Assume that the current level of the S&P ASX 200 index is 4,500 points, the volatility of the index is 35% p.a., the continuous dividend yield on the index is 3.0% p.a. and the nine-month risk free rate (continuously compounded) is 5.0% p.a.


(a) Use a five-period binomial option pricing model to value a nine-month American put option on the S&P ASX 200 index with an exercise price of 4,750 points. Show the binomial tree diagram.

(b) What is the value of the "right of early exercise"?

Posted Date: 2/22/2013 4:23:00 AM | Location : United States

Related Discussions:- binomial option pricing model , Assignment Help, Ask Question on binomial option pricing model , Get Answer, Expert's Help, binomial option pricing model Discussions

Write discussion on binomial option pricing model
Your posts are moderated
Related Questions
#qusuppose that a bank sole business is to lend in two region of the world. The lending in each region Has the same characteristic as in example 21.5 of section 21.8. Lending to

Part 1: Contingency plan Create contingency plans for the following scenarios: > One of your highly qualified consultants has given three months notice and is planning to move to a

In its early stages, the financial crisis manifested itself as an acute liquidity shortage among financial intermediaries. In this phase, concerns over the solvency of the sophisti

Risk is inherent in business and hence there is no escape from the risk for a businessman. However, he may face this problem with greater confidence if he adopts a scientific appro

Question: For each of the situations below:- (a) Mention most relevant clause of ISO 27001:2005 (b) Whether the practice followed in the organization is appropriate and i

what are the computations of risk ratios?

Determine a process for communicating, resourcing and managing risk management strategies Establish a communication plan to implement the risk management framework that has been

Question: a) Using illustrative and numerical example, differentiate between speculation and arbitraging in the context of foreign exchange market. b) One year borrowing and

What is the monetary certainty equivalent, Risk Management