FINANCIAL MODELLING AND

D E R I VAT I V E S
TUTORIAL WEEK 5

1
QUESTION 0
• Please fill in your name and student number on Mentimeter in the following format:
• Student number, name
• Example: 1234567, Mark Dijkstra
• Please insert your information correctly, especially your student number! This makes
grading easier. Deal sweetener: Any student that inputs their student number
correctly for every week of the tutorial gets 5 bonus points on the tutorial!

2
QUESTION 1
• What is the value of a call option with exercise price €50 at expiration when the
stock price is €60? What if the stock price is €40?
A. Stock=60: Call= 0 Stock=40: Call= 0
B. Stock=60: Call= 10 Stock=40: Call= 0
C. Stock=60: Call= 0 Stock=40: Call= −10
D. Stock=60: Call= 10 Stock=40: Call= −10

3
 S1,max = € 60
c1,max = € 10
S0= € 50
S1,min = € 40
QUESTION 1 c1,min = € 0

• Situation 𝑆𝑇 = 60
• c = max 0, 𝑆𝑇 − 𝐾 = max 0,60 − 50 = €10
• 𝑆𝑇 > 𝐾
• An option is the right to exercise and not the
Pay-off call at maturity
obligation.
• You have the right to buy the underling stock for €50
while it currently trades for €60. You exercise the
call option.

• The correct answer is: B

4
 S1,max = € 60
c1,max = € 10
S0= € 50
S1,min = € 40
QUESTION 1 c1,min = € 0

• Situation 𝑆𝑇 = 40
• c = max 0, ST − K = max 0,40 − 50 =
max 0, −10 = 0
• 𝑆𝑇 < 𝐾 Pay-off call at maturity

• An option is the right to exercise and not the

obligation.
• You have the right to buy the underling stock for
€50 while it currently trades for €40. So you
simply choose not to exercise the call option.

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QUESTION 2
• Suppose you wrote a European call option on Swanson Woodworking at an
exercise price of $45 (i.e. you went short on a call option). If the share price on
Swanson Woodworking at the exercise date is $48, how much money did you gain
or lose? (for illustrative purposes, the price of the option is ignored in this question)
A. $-3 (you lose $3)
B. $0 (you gain/lose nothing)
C. $3 (you gain $3)
D. $48 (you gain $48)

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QUESTION 2
• The share price is above the exercise price, so
the call option will be exercised.
• Since you wrote the option, this means that the
option holder can buy the share from you at
$45 (you sold the right to buy the share).
• The share price is $48, so you effectively lost
$3
• The correct answer is: A

7
QUESTION 3
• Shares of pony farm Little Sebastian are selling for €11. A one-year European put
option with a €10 exercise price is priced at €0.39. The risk-free rate is 5 percent
per annum, annually compounded. What is the value of an equivalent (same
exercise price, date, type) call option?
A. €0.70
B. €1.28
C. €1.69
D. €1.87

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QUESTION 3
• Put-call parity:
𝐾
• 𝑝0 + 𝑆0 = 𝑐0 +
1+𝑟 𝑇

Protective put Call + bond

Value of Value at maturity Value at maturity

• 0.39 + 11 = 𝑐0 + 10/1.05 portfolio today if 𝑺𝑻 < 𝑲 if 𝑺𝑻 > 𝑲
• 𝑐0 = 0.39 + 11 − 10/1.05 𝑝0 + 𝑆0 max 0, 𝐾 − 𝑆𝑇 + 𝑆𝑇 max 0, 𝐾 − 𝑆𝑇 + 𝑆𝑇
= 𝐾 − 𝑆𝑇 + 𝑆𝑇 = 𝐾 = 0 + 𝑆𝑇 = 𝑆𝑇
• 𝑐0 = €1.87
𝑐0 + 𝐾𝑒 −𝑟𝑇 max 0, 𝑆𝑇 − 𝐾 + 𝐾 max 0, 𝑆𝑇 − 𝐾 + 𝐾
• The correct answer is: D =0+𝐾 =𝐾 = 𝑆𝑇 − 𝐾 + 𝐾 = 𝑆𝑇

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QUESTION 4
• Same share: Shares of pony farm Little Sebastian are selling for €11. A one-year
European put option with a €10 strike price is priced at €0.39. The risk-free rate
is 5 percent per annum. We just calculated the value of an equivalent call option is
€1.87. What is the intrinsic value of the call option? What is the time premium?
A. Intrinsic value = €1.87; Time premium = €0
B. Intrinsic value = €1; Time premium = €0.87
C. Intrinsic value = €0; Time premium = €1.87
D. Intrinsic value = €-1; Time premium = €2.87

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QUESTION 4
• Intrinsic value
• Value of the option if exercised immediately
• 𝑆0 − 𝐾 = €11 − €10 = €1
• Time premium
• Option premium minus intrinsic value
• €1.87 − €1 = €0.87
• The correct answer is: B

11
QUESTION 5
• For a put option, an increase in the variance of the underlying asset leads to ____
in the value of the option
A. An increase
B. A decline
C. No change
D. Impossible to say

12
QUESTION 5
• An increase in the variance of the underlying asset leads to an increase in the value of the put
option.
• The asymmetric pay-off is the key aspect.
• If volatility increases, the chance of large price movements in the underlying asset is higher.
• With a put option you want the price of the underlying asset to fall. If the volatility of the underlying
increases, your chance of large pay-offs increases.
• With a put option you don’t want the price of the underlying asset to increase. However, your risk is
limited (remember that it is the right to exercise, and not the obligation)
• Thus, with a put option you benefit from higher volatility in the underlying asset as you benefit from price
drops while the risk of a price increase is limited.

• The correct answer is: A

13
QUESTION 6
• In one year a share of Regal Meagle Realtors will be worth either $40 or $30. If
the risk-free rate is 5% and a share of Regal Meagle sells for $35 currently, what
is the delta of a call option with an exercise price of $25?
A. 0
B. 0.25
C. 0.5
D. 1

14
QUESTION 6
𝑐𝑢 −𝑐𝑑 15−5
• Δ= = =1
𝑆1,𝑢 −𝑆1,𝑑 40−30

• The call is always in the money.

• If the underlying asset increases by $1, the
option will increase by ≈ $1 (= Δ). S1,u = $40
cu = $15
• The correct answer is: D
S0=$ 35
S1,d = $30
cd = $5

15
QUESTION 7
• (same share) In one year a share of Regal Meagle Realtors will be worth either
$40 or $30. If the risk-free rate is 5% (compounded annually) and a share of
Regal Meagle sells for $35 currently, what is the price of a call option with an
exercise price of $25?
A. $10.00
B. $10.84
C. $11.19
D. $12.05

16
QUESTION 7
• 𝐶 = Δ𝑆 + 𝐵
• Value derivative = value replicating portfolio
𝐶𝑑 −𝑆𝑑 Δ max 0,40 − 25 = 15
• C = Δ𝑆 +
(1+𝑟)𝑇
• From the previous question we know that Δ = 1
5−30∙1
• 𝐶 = 1 ∙ 35 + S1,u = $40
1.05
cu = $15
• 𝐶 = 35 − 23.81 = $11.19
• You borrow $23.81 and buy 1(= Δ) stock to S0=$ 35
replicate the call option S1,d = $30
• The correct answer is: C cd = $5

17
QUESTION 8
• Which one of the following describes the lower bound of an American call option's
value?
A. Strike price or zero, whichever is greater
B. Share price minus the exercise price or zero, whichever is greater
C. Strike price or the share price, whichever is lower
D. Strike price or zero, whichever is lower

18
QUESTION 8
• If the call option would have a lower price, an
arbitrage profit could be made by buying the
option for C and immediately exercising it,
making 𝑆 − 𝐾.
• If 𝐶 < 𝑆 − 𝐾, this would mean a riskless
profit.
• A Call option can never be worth less than its
intrinsic value: 𝐶 ≥ max 𝑆0 − 𝐾/(1 + 𝑟)𝑇 , 0
• The correct answer is: B

19
QUESTION 9
• Suppose petstore Mouserat’s share price is 80 and the exercise price on a one-
year European call option is 90. The price of Mouserat will be either 75 or 95 in
one year. What is the delta of a one-year call option?
A. 0
B. 0.25
C. 0.5
D. 1

20
QUESTION 9
• 𝑐𝑢 = max 0, 95 − 90 = 5
• 𝑐𝑑 = max 0, 75 − 90 = 0
𝑐𝑢 −𝑐𝑑 5−0
• 95Δ − 5 = 75Δ − 0 → Δ = = = 0.25
𝑆1,𝑢 −𝑆1,𝑑 95−75
S1,u = $95
• The correct answer is: B cu = $5
S0=$ 80
S1,d = $75
cd = $0

21
QUESTION 10
• Same share: Suppose petstore Mouserat’s share price is 80 and the exercise price
on a one-year European call option is 90. The price of Mouserat will be either 75
or 95 in one year. What is the value of a one-year European call option if the
risk-free rate is 6%, compounded annually?
A. 1.85
B. 2.05
C. 2.31
D. 2.45

22
QUESTION 10
• 𝑐 = ∆𝑆 + 𝐵 =
• Value derivative = value replicating portfolio
𝐶𝑑 −𝑆𝑑 ∆
• 𝑐 = ∆𝑆 +
(1+𝑟)𝑇
• We know Δ from the previous question S1,u = $95
0−75∙0.25 cu = $5
• 𝑐 = 0.25 ∙ 80 +
1.06 S0=$ 80
• 𝑐 = 20 − 17.69 = 2.31 S1,d = $75
cd = $0
• The correct answer is: C

23
QUESTION 10
• Note that the same answer value can be obtained with risk-neutral pricing:
𝑆0 (1+𝑟)𝑇 −𝑆1,𝑑 80∗1.06−75
• 𝜌= = = 0.494
𝑆1,𝑢 −𝑆1,𝑑 95−75
1
•𝑐= 𝜌 ∙ 𝑐𝑢 + 1 − 𝜌 ∙ 𝑐𝑑
1.06 S1,u = $95
1 cu = $5
•𝑐= 0.494 ∙ 5 + 0.506 ∙ 0
1.06
S0=$ 80
2.45
•𝑐= = $2.31 S1,d = $75
1.06
cd = $0
• The correct answer is: C

24
QUESTION 11
• Same share: Suppose petstore Mouserat’s share price is 80 and the exercise price
on a one-year call option is 90. The price of Mouserat will be either 75 or 95 at
the end of the year. What is the value of a one-year European put option if the
risk-free rate is 6%? (equivalent call option price = 2.31)
A. 5.65
B. 7.10
C. 7.22
D. 12.31

25
QUESTION 11
• Put-Call Parity: Protective put (= put + stock) = Call + Bond
𝐾
• 𝑝 + 𝑆0 = 𝑐 +
1+𝑟 𝑇
90
• 𝑝 + 80 = 2.31 +
1.06
• 𝑝 = 2.31 + 84.91 − 80 = $7.22
• The correct answer is: C
• Note that the replicating portfolio approach also works for put options: S1,u = $95
𝑝𝑢 −𝑝𝑑 0−15 pu = $0
• 95Δ − 0 = 75Δ − 15 → Δ = = = −0.75
𝑆1,𝑢 −𝑆1,𝑑 95−75

𝑝𝑑 −𝑆𝑑 ∆ 15−75∙−0.75
S0=$ 80
• 𝑝 = ∆𝑆 + = −0.75 ∙ 80 +
(1+𝑟)𝑇 1.06
S1,d = $75
• 𝑝 = −60 + 67.22 = 7.22
pd = $15

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QUESTION 12
Which of the following statements is FALSE?
A. Because an American option cannot be worth less than its intrinsic value, it cannot
have a negative time value
B. An American option with a later exercise date cannot be worth less than an
otherwise identical American option with an earlier exercise date
C. The value of an option generally decreases with the volatility of the stock
D. The intrinsic value is the amount by which the option is currently in-the-money or 0
if the option is out-of-the-money

27
QUESTION 12
Which of the following statements is FALSE?
A. Because an American option cannot be worth less than its intrinsic value, it cannot have a negative
time value
B. An American option with a later exercise date cannot be worth less than an otherwise identical
American option with an earlier exercise date
C. The value of an option generally decreases with the volatility of the stock
D. The intrinsic value is the amount by which the option is currently in-the-money or 0 if the option is
out-of-the-money

• The correct answer is: C

• Explanation: The value of an option generally increases with the volatility of the stock.
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QUESTION 13
• The current price of Dwyer-Ludgate Industries stock is $20. In the next year, the stock
price will either go up by 20% or go down by 20%. Dwyer-Ludgate pays no dividends.
The one-year risk-free rate is 5%, annually compounded.
• The risk-neutral probability of an up state for Dwyer-Ludgate Industries is closest to:
A. 37.5%
B. 42.5%
C. 57.5%
D. 62.5%

29
QUESTION 13
• Risk-neutral probability of up-state:
𝑆(1+𝑟)𝑇 −𝑆𝑑 20∗1.05−16
• 𝜌= = = 0.625 or 62.5%
𝑆𝑢 −𝑆𝑑 24−16

• Important: this is a risk-neutral probability and not a real-world probability of an

up-movement
• The correct answer is: D

30
QUESTION 14
• (same stock): The current price of Dwyer-Ludgate Industries stock is $20. In the next year,
the stock price will either go up by 20% or go down by 20%. Dwyer-Ludgate pays no
dividends. The one-year risk-free rate is 5%, annually compounded.
• The risk-neutral probability of a down state for Dwyer-Ludgate Industries is closest to
(risk-neutral probability of an up-state was 62.5%):
A. 37.5%
B. 42.5%
C. 57.5%
D. 62.5%.

31
QUESTION 14
• Probability of down-state = 1 – probability of up-state
• 1 − 𝜌 = 1 − 0.625 = 0.375 or 37.5%
• The correct answer is: A

32
QUESTION 15
• (same stock) The current price of Dwyer-Ludgate Industries stock is $20. In the next year,
the stock price will either go up by 20% or go down by 20%. Dwyer-Ludgate pays no
dividends. The one-year risk-free rate is 5%, annually compounded.
• Using risk-neutral probabilities (𝜌 = 0.625), the calculated price of a one-year call
option on Dwyer-Ludgate stock with a strike price of $20 is closest to:
A. $1.45
B. $2.15
C. $2.38
D. $2.50

33
QUESTION 15
• 𝑐𝑢 = max 0, 𝑆𝑇 − 𝐾 = max 0; 20 ∙ 1.2 − 20 = 4
• 𝑐𝑑 = max 0, 𝑆𝑇 − 𝐾 = max 0; 20 ∙ 0.8 − 20 = 0
𝜌𝑐𝑢 +(1−𝜌)𝑐𝑑 0.625∙4+0.375∙0
•𝑐= = = $2.38
(1+𝑟)𝑇 1.05

• The correct answer is: D S1,u = $24

cu = $4
S0=$20
S1,d = $16
cd = $0

34
QUESTION 16
• Please fill in your name and student number on Mentimeter in the following format:
• Student number, name
• Example: 1234567, Mark Dijkstra
• Please insert your information correctly, especially your student number! This makes
grading easier. Deal sweetener: Any student that inputs their student number
correctly for every week of the tutorial gets 5 bonus points on the tutorial!

35
QUIZZES
• Don’t forget to take the quiz on Thursday
• 7:00 – 21:00
• Correct answers are shown after 22:00
• Use a decimal point and a comma as thousands separator
• For example: 12,345.67

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