Binomial Option Pricing Model - Calculating n

CFA Level II
#1

Don’t know if this is an error? Chapter 56, EOC Q #3 & 5 seem to have different formulas in the answer key for calculating n on puts:

Q3: n=(p+ - p-)/(S+ - S-)

Q5: n=(p- - p+)/S+ - S-)

Anyone understand this formula enough to say if this is just an error? For calls and in the text it looks like it should be the first.

#2

there is no error.

question 3 is creating an arbitrage profit by selling 10 000 puts and shorting the delta amount of share. so the formula is reverse.

question 5 want to hedge is LONG position in puts, to hedge a position of long puts, you need to buy delta share in order to reverse the profit you make in the put position. so you need a positive delta.

don’t worry about the p+ - p- side, just worry about what you want to hedge. a long put or a short put?

good luck

#3

Thanks…I know it doesn’t change the absolute # but it changes the sign. I thought for Q3 we both shorted the put and shorted the shares because it was negative.

#4

Honestly, I was confused by this as well. I ended up just using the same formula for all of them, then stepping back and looking at the hedging situation. ie: you know that if you are LONG the puts, the hedge would be BUYING the underlying stock. But that’s just me…

#5

What you need to do – look at the Put Call Parity …

In its standard form

P + S = C+X/(1+r)^T

So if you are short a Call you must be long a Stock -> they are on opposite sides of the equation.

If you are Long a Put, you should also be Long a Stock (Same side of the equation).