# problem solving in financial mathematics

## a companion blog for a blog on option pricing models # Pricing European options using multiperiod binomial trees

Practice problems in this post reinforce the following blog post on multiperiod binomial option pricing calculation:

found in this companion blog.

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Practice Problems

Practice Problem 1
The following gives the information on a particular stock.

• The current stock price is $40. • The stock is non-dividend paying. • The annual standard deviation of the stock return is $\sigma=$ 0.3. • The annual risk-free interest rate is $r=$ 5%. Price a 6-month European put option on this stock using a 2-period binomial tree. The strike price of the option is$45. Include the replicating portfolio on each node in the binomial tree.

Practice Problem 2
Calculate the price of a 6-month European call option on a certain stock with the following characteristics:

• The initial stock price is $60. • Strike price of the call option is$55.
• The stock is non-dividend paying.
• The annual standard deviation of the stock return is $\sigma=$ 0.3.
• The annual risk-free interest rate is $r=$ 4%.

Use a 2-period binomial tree. Include the replicating portfolio on each node in the binomial tree.

Practice Problem 3
The following gives the information on a 3-month European put option:

• The initial stock price is $40. • Strike price of the call option is$45.
• The stock is non-dividend paying.
• The annual standard deviation of the stock return is $\sigma=$ 0.3.
• The annual risk-free interest rate is $r=$ 5%.

Price this put option using a 3-period binomial tree. Include the replicating portfolio on each node in the binomial tree.

Practice Problem 4
The following gives the information on a 2-year European call option:

• The initial stock price is $50. • Strike price of the call option is$60.
• The stock pays dividends at the annual continuous rate of $\delta=$ 5%.
• The annual standard deviation of the stock return is $\sigma=$ 0.3.
• The annual risk-free interest rate is $r=$ 2%.

Price this call option using a 3-period binomial tree. Include the replicating portfolio on each node in the binomial tree. $\text{ }$
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Answers $\text{ }$

Practice Problem 1 – pricing 6-month European put $\text{ }$ $\displaystyle \begin{array}{lllll} \displaystyle \text{Initial Price} & \text{ } & \text{Period 1} & \text{ } & \text{Period 2} \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & S_{uu}=\ 55.36122584 \\ \text{ } & \text{ } & \text{ } & \text{ } & C_{uu}=\ 0 \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & S_u=\ 47.05793274 & \text{ } & \text{ } \\ \text{ } & \text{ } & C_u=\ 2.116325081 & \text{ } & \text{ } \\ \text{ } & \text{ } & \Delta=-0.277893964 & \text{ } & \text{ } \\ \text{ } & \text{ } & B= \ 15.19344057 & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ S= \ 40 & \text{ } & \text{ } & \text{ } & S_{ud}=\ 41.01260482 \\ C=\ 6.051211415 & \text{ } & \text{ } & \text{ } & C_{ud}=\ 3.98739518 \\ \Delta=-0.611918665 & \text{ } & \text{ } & \text{ } & \text{ } \\ B= \ 30.52795801 & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & S_d=\ 34.861374 & \text{ } & \text{ } \\ \text{ } & \text{ } & C_d=\ 9.579627019 & \text{ } & \text{ } \\ \text{ } & \text{ } & \Delta=-1 & \text{ } & \text{ } \\ \text{ } & \text{ } & B= \ 44.44100102 & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & S_{dd}=\ 30.38288493 \\ \text{ } & \text{ } & \text{ } & \text{ } & C_{dd}=\ 14.61711507 \end{array}$ $\text{ }$ $\text{ }$

Practice Problem 2 – pricing 6-month European call $\text{ }$ $\displaystyle \begin{array}{lllll} \displaystyle \text{Initial Price} & \text{ } & \text{Period 1} & \text{ } & \text{Period 2} \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & S_{uu}=\ 82.627665586 \\ \text{ } & \text{ } & \text{ } & \text{ } & C_{uu}=\ 27.62766586 \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & S_u=\ 70.41065226 & \text{ } & \text{ } \\ \text{ } & \text{ } & C_u=\ 15.9579114 & \text{ } & \text{ } \\ \text{ } & \text{ } & \Delta=1 & \text{ } & \text{ } \\ \text{ } & \text{ } & B=- \ 54.45274086 & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ S= \ 60 & \text{ } & \text{ } & \text{ } & S_{ud}=\ 61.2120804 \\ C=\ 8.821942361 & \text{ } & \text{ } & \text{ } & C_{ud}=\ 6.2120804 \\ \Delta=0.718552622 & \text{ } & \text{ } & \text{ } & \text{ } \\ B=- \ 34.291215 & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & S_d=\ 52.16149412 & \text{ } & \text{ } \\ \text{ } & \text{ } & C_d=\ 2.844930962 & \text{ } & \text{ } \\ \text{ } & \text{ } & \Delta=0.391557423 & \text{ } & \text{ } \\ \text{ } & \text{ } & B=- \ 17.57928923 & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{ } & S_{dd}=\ 45.34702449 \\ \text{ } & \text{ } & \text{ } & \text{ } & C_{dd}=\ 0 \end{array}$ $\text{ }$ $\text{ }$

Practice Problem 3 – pricing 3-month European put $\text{ }$ $\displaystyle \begin{array}{llll} \displaystyle \text{Initial Price} & \text{Period 1} & \text{Period 2} & \text{Period 3} \\ \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & S_{uuu}=\ 52.51963372 \\ \text{ } & \text{ } & \text{ } & C_{uuu}=\ 0 \\ \text{ } & \text{ } & S_{uu}=\ 47.96242387 & \text{ } \\ \text{ } & \text{ } & C_{uu}=\ 0.432623115 & \text{ } \\ \text{ } & \text{ } & \text{ } & S_{uud}=\ 44.16718067 \\ \text{ } & \text{ } & \text{ } & C_{uud}=\ 0.83281933 \\ \text{ } & S_u=\ 43.80065016 & \text{ } & \text{ } \\ \text{ } & C_u=\ 2.532353895 & \text{ } & \text{ } \\ S=\ 40 & \text{ } & S_{ud}=S_{du}=\ 40.33472609 & \text{ } \\ C=\ 5.253907227 & \text{ } & C_{ud}=\ 4.478163995 & \text{ } \\ \text{ } & S_d=\ 36.83481952 \text{ } & \text{ } \\ \text{ } & C_d=\ 7.79173865 \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & S_{udd}=\ 37.1430589 \\ \text{ } & \text{ } & \text{ } & C_{udd}=\ 7.856941105 \\ \text{ } & \text{ } & S_{dd}=\ 33.92009822 & \text{ } \\ \text{ } & \text{ } & C_{dd}=\ 10.89279186 & \text{ } \\ \text{ } & \text{ } & \text{ } & S_{ddd}=\ 31.2360174 \\ \text{ } & \text{ } & \text{ } & C_{ddd}=\ 13.7639826 \\ \end{array}$ $\text{ }$ $\text{ }$

Practice Problem 3 – pricing 3-month European put – Replicating portfolios $\text{ }$ $\displaystyle \begin{array}{llll} \displaystyle \text{Initial Price} & \text{Period 1} & \text{Period 2} & \text{Period 3} \\ \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \Delta=-0.099709549 & \text{ } \\ \text{ } & \text{ } & B=\ 5.21493479 & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \Delta=-0.530375088 & \text{ } & \text{ } \\ \text{ } & B=\ 25.76312758 & \text{ } & \text{ } \\ \Delta=-0.755026216 & \text{ } & \Delta=-1 & \text{ } \\ B=\ 35.45495588 & \text{ } & B=\ 44.81289008 & \text{ } \\ \text{ } & \Delta=-1 \text{ } & \text{ } \\ \text{ } & B=\ 44.62655817 \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \Delta=-1 & \text{ } \\ \text{ } & \text{ } & B=\ 44.81289008 & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \end{array}$ $\text{ }$ $\text{ }$

Practice Problem 4 – pricing 2-year European call $\text{ }$ $\displaystyle \begin{array}{llll} \displaystyle \text{Initial Price} & \text{Period 1} & \text{Period 2} & \text{Period 3} \\ \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & S_{uuu}=\ 98.18661752 \\ \text{ } & \text{ } & \text{ } & C_{uuu}=\ 38.18661752 \\ \text{ } & \text{ } & S_{uu}=\ 78.40760726 & \text{ } \\ \text{ } & \text{ } & C_{uu}=\ 16.63179043 & \text{ } \\ \text{ } & \text{ } & \text{ } & S_{uud}=\ 60.15785233 \\ \text{ } & \text{ } & \text{ } & C_{uud}=\ 0.15785233 \\ \text{ } & S_u=\ 62.61294086 & \text{ } & \text{ } \\ \text{ } & C_u=\ 7.243606191 & \text{ } & \text{ } \\ S=\ 50 & \text{ } & S_{ud}=S_{du}=\ 48.03947196 & \text{ } \\ C=\ 3.154705319 & \text{ } & C_{ud}=\ 0.068389797 & \text{ } \\ \text{ } & S_d=\ 38.36225491 \text{ } & \text{ } \\ \text{ } & C_d=\ 0.029629999 \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & S_{udd}=\ 36.85804938 \\ \text{ } & \text{ } & \text{ } & C_{udd}=\ 0 \\ \text{ } & \text{ } & S_{dd}=\ 29.43325204 & \text{ } \\ \text{ } & \text{ } & C_{dd}=\ 0 & \text{ } \\ \text{ } & \text{ } & \text{ } & S_{ddd}=\ 22.58251835 \\ \text{ } & \text{ } & \text{ } & C_{ddd}=\ 0 \\ \end{array}$ $\text{ }$ $\text{ }$

Practice Problem 4 – pricing 2-year European call – Replicating portfolios $\text{ }$ $\displaystyle \begin{array}{llll} \displaystyle \text{Initial Price} & \text{Period 1} & \text{Period 2} & \text{Period 3} \\ \text{ } & \text{ } & \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \Delta=0.9672161 & \text{ } \\ \text{ } & \text{ } & B=-\ 59.20530971 & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \Delta=0.527539397 & \text{ } & \text{ } \\ \text{ } & B=-\ 25.78718685 & \text{ } & \text{ } \\ \Delta=0.287722745 & \text{ } & \Delta=0.00655273 & \text{ } \\ B=-\ 11.23143192 & \text{ } & B=-\ 0.246399887 & \text{ } \\ \text{ } & \Delta=0.00355514 \text{ } & \text{ } \\ \text{ } & B=-\ 0.106753181 \text{ } & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \Delta=0 & \text{ } \\ \text{ } & \text{ } & B=\ 0 & \text{ } \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \text{ } & \text{ } & \text{ } & \text{N/A} \\ \end{array}$ $\text{ }$

For more information on how to calculate the option prices for these practice problems, refer to The binomial option pricing model, part 4.

_____________________________________________________________________________________ $\copyright \ 2015 \text{ by Dan Ma}$

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