Risk and Derivative

Assignment B Feedback

Part 1

The grade out of 10 marks is split as follows

* 7 marks for subject knowledge

* 3 marks for excel use and formatting

Subject knowledge

Below is a snapshot of what the calculations should have resulted in for part a). Note that df is just the one period discount factor based ono the risk free rate e-rf * dt. You weren’t required to separate this out.

Common mistakes here were

* Using the variance of 0.18 given in the question instead of the standard deviation of 0.4242.

* Using the wrong time increment for each step. The amount of time between steps was dt = 0.08333 years. This number should have been driving both the u and d parameters as well as the discount factor.

* Setting up the u parameter with e-rf * dt instead of erf * dt.

* Failing to check for early exercise!!! This resulted in the loss of an entire mark. There were several points in the bottom half of the tree were early exercise would have been preferable to holding the option. Failing to check this led to an option price that was around $1.39.

* Several people had tried to hard code in at each node whether or not the option price was found via the discounting formula from the binomial model or from early exercise. That is to say, their calculations seem to be one or the other as opposed to a more general formula which gave the maximum of both. This generally led to mistakes and is not good practice. In excel, it is best to set up your spreadsheet so that a small change to the inputs at the start completely filter through the subsequent calculations. This leads to fewer mistakes.

The graphs I was seeking for parts b) and c) should have looked something like the ones below (though they could definitely be formatted a little better than this one). Common problems here were the following.

* Only plotting this for a representative stock and option. That is not what the question asked for.

* Only plotting one of...