Option Valuation Methods (2016!01!27)

1
Technische Universiteit Delft

Fac. Elektrotechniek, Wiskunde en Informatica
Examination Valuation of Derivatives, Wi 3405TU

Friday January 27nd 2016, 9:00 - 11:00 (2 hours examination)
1. Consider the Black-Scholes equation:
∂V ∂V 1 2 2 ∂ 2V
+ rS + σ S − rV = 0,
∂t ∂S 2 ∂S 2
with a payoff function as the final condition at t = T .
a. Show that the transformations S = ey , τ = T − t, and v(y, τ ) =

erτ V (y, τ ), followed by x = y + (r − 12 σ 2 )τ result in the following
heat equation for unknown u(x, τ ),
∂u 1 ∂ 2u
= σ2 2 ,
∂τ 2 ∂x
Answer: One starts with the Black-Scholes equation
∂V ∂V 1 ∂ 2V
+ rS + σ 2 S 2 2 − rV = 0,
∂t ∂S 2 ∂S
supplemented with the terminal and boundary conditions. The
change of independent variables S = ey , t = T − τ , results in
∂ ∂ ∂ ∂
→
S , =− ,
∂S ∂y ∂t ∂τ
1 ∂ 2V

∂V 1 2 ∂V
− r− σ − σ 2 2 + rV = 0.
∂τ 2 ∂y 2 ∂y
If we replace v(y, τ ) = erτ V (y, τ ), we will obtain:
1 2 ∂v 1 2 ∂ 2 v

∂v
− r− σ − σ = 0,
∂τ 2 ∂y 2 ∂y 2
The substitution x = y + (r − σ/2)τ allows us to eliminate the

first-order term, and to reduce the preceding equation to the form
with dependent variable u(x, τ ):
∂u 1 ∂ 2u
= σ2 2 ,
∂τ 2 ∂x
2
b. Write down the Forward-in-Time Central-in-Space scheme, FTCS,

for this heat equation. Show that the discrete scheme is second-
order accurate in space and first-order accurate in time.
Answer: The FTCS scheme for this heat equation is exactly as
(23.7) on page 241, except a multiplication by σ 2 /2. The accuracy
is discussed and derived, based on the Taylor expansion, on pages
246, 247 in Equations (23.13), (23.14).
c. Apply von Neumann stability analysis for this heat equation. Show
that the stability condition takes the form σ 2 ∆τ ≤ (∆x)2 .
Answer: This is the derivation on page 248, which needs to be
done properly by the student, and the result follows from the
inclusion of the term σ 2 /2.
2. A double barrier option has two barriers, B1 and B2 , one above and
one below the current stock price, B1 < S0 < B2 < E. In a one-
touch double barrier put option, the option is knocked out, resulting in
a valueless option, if at least one of the barriers is breached during the
life of the option.
We assume that the asset follows the process that leads to the Black-
Scholes equation:
∂V ∂V 1 ∂ 2V
+ rS + σ 2 S 2 2 − rV = 0.
∂t ∂S 2 ∂S
a. Why would an investor buy such an option, and why would a
writer sell such an option?
Answer: A writer would sell such an option because it may be
relatively easy to hedge it, and the possible losses in the case of
an unhedged position may be limited as the pay-off is strictly
bounded.
An investor would buy such an option if he/she has very specific
views about the possible size of the asset movements, and thinks
that the movement stays with the [B1 , B2 ] range. With a some-
what limited pay-off the option is cheaper than a usual put option.
However, it can be mentioned that also a usual put option has a
limited payoff. The current one is however cheaper.
b. Transform the equations by τ = T − t into forward equations
in time. Give the appropriate computational domain, the cor-
responding boundary conditions and the payoff function for the
one-touch double barrier put option.
Answer: The computational domain is from B1 to B2 . On both
boundaries the barrier put option values equals 0. The payoff
is the put payoff, provided that the asset value stays within the
range [B1 , B2 ]. This payoff is now an initial condition, as we have
to transform the PDE to an equation forward in time.
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c. Which standard (single) barrier options should be in a portfolio

with this double barrier option in order to replicate a regular Eu-
ropean put option?
Answer: With the notion, in the case of single barrier options,
barrier ”in + out = European option”, we need, in the case of a
double barrier option, a ”down-and-in” barrier put option, with
barrier B1 , and an ”up-and-in” barrier option, with barrier level
B2 to guarantee that also in the double barrier case, we end up
with a European put option payoff.
d. Why does it not make much sense to have B < E, with E the
strike price, in an up-and-in barrier call option?
Answer: When B < E in an up-and-in barrier call option, the
situation would just resemble a regular call option. The option
gets in the money once the stock price passes barrier B, but it has
to move further (S > E) to end up in the money. So, it would
just be equal to a common call option, and therefore it would be
silly to have a barrier there.
3. The following Matlab code is given:
%%%%%%%%%% Problem and method parameters %%%%%%%%%%%%%

S = 3; E = 2; T = 1; r = 0.05; sigma = 0.3;
M = 400; dt = T/M; p =0.5;
u = exp(sigma*sqrt(dt) + (r-0.5*sigma^2)*dt);
d = exp(-sigma*sqrt(dt) + (r-0.5*sigma^2)*dt);
%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%
% Time T option values

W = max(E-S*d.^([M:-1:0]’).*u.^([0:M]’),0);
% Work back to option value at time zero

for i = M:-1:1
W = exp(-r*dt)*(p*W(2:i+1) + (1-p)*W(1:i));
end
disp(’Option value is’), disp(W)
– What is the computational technique in this Matlab code and

what is computed? Adapt the Matlab code above to value a
Bermudan put option with two early-exercise dates, at t = 0.5
and at T = 1.
Answer: This is the computation by means of the binomial tree
model of a European put option., with 400 time steps.
If we need to compute a Bermudan option, with exercise at t = 0.5
and at T = 1, we’d need to add a statement that when we reach
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t=0.5 (time step 200) we have to choose the maximum of con-

tinuation value, which is now ialready computed in the European
case, and the payoff function. So, we’d exercise when the payoff
value is higher than the continuation value. We need not change
the code for intermediate time steps, when we just need to com-
pute accurate continuation values. Also at final time, exercise is
automatically taken into account here.
Place your name and study number on each page with solutions.

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1

Technische Universiteit Delft

Examination Valuation of Derivatives, Wi 3405TU

1. Consider the Black-Scholes equation:

a. Show that the transformations S = ey , τ = T − t, and v(y, τ ) =

Answer: One starts with the Black-Scholes equation

The substitution x = y + (r − σ/2)τ allows us to eliminate the

b. Write down the Forward-in-Time Central-in-Space scheme, FTCS,

c. Which standard (single) barrier options should be in a portfolio

3. The following Matlab code is given:

%%%%%%%%%% Problem and method parameters %%%%%%%%%%%%%

% Time T option values

% Work back to option value at time zero

disp(’Option value is’), disp(W)

– What is the computational technique in this Matlab code and

t=0.5 (time step 200) we have to choose the maximum of con-

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