You are on page 1of 2

# (Value of Deferring with uncertainty) Factory can be built instantly at a cost of \$1600.

. It produces 1 widget a year forever with zero operating costs. Risk is fully diversifiable. The risk free rate is 10% Price of widgets are \$200. Next year they will increase to \$300, with probability 0.5, or decrease to \$100 with probability 0.5. The prices then remain fixed forever. NPV = -1,600 + 200 + 200[1/(1.1) + 1/(1.1)2+.]=-1,600 + 200 + 200/0.10 = -1600 + 200 + 2000 = 600 How do we establish the discount rate? If the NPV is positive, and if it is now or never, then proceed. If the NPV is positive, and you can always get your investment back (full salvage value) then proceed. If the project is irreversible, and you could wait, then a positive NPV does not mean go ahead. Say we could wait one year. Valuing a Deferral Option NPV =0.5Max{0, -1,600/1.1 + 300[1/1.1+1/(1.1)2+.]} + 0.5Max{0, -1600/1.1 + 100[1/1.1 +1.(1.1)2+]} = 0.5Max{0,-1600/1.1 +300/0.10} + 0.5Max{0,-1600/1.1 + 100/0.10 } =0.5Max{0, 1545.45} + 0.5Max{0,-454} =772.72 + 0 = \$772.72 Value of deferring = 772.72-600 = \$172.72 We would pay up to \$172.72 to defer the decision Valuing a Deferral Option with Larger Volatility What happens if there is more uncertainty? (Prices are \$400 or \$0 next year and on..) NPV = 0.5Max{0, -1,600/1.1 + 400[1/(1.1)+1/(1.1)2+.]} + 0.5Max{0, -1600/1.1 +0[1/1.1 +1.(1.1)2+]} = 0.5Max(0, 2545) + 0.5Max(0,-1454.54) = 1272 Value of deferring =1272-600 = 672 Value of deferring increases with volatility! The value of waiting has increased. This is a general result for options. When uncertainty increases in the economy, one would predict that investment would decline because it becomes worth more to wait and see what happens There are situations where a firm cannot wait Entry of a competitor Patent or mineral lease that is about to expire The less time there is to delay, the less irreversibility affects the Investment decision Treat the project as an option The decision to invest is analogous to the decision to exercise an option. Exercise price ~ investment cost Underlying asset ~ value of the project Tradeoff between factors: If you exercise you get cash flow from selling widgets ( dividends) you exercise you pay the strike price now. You lose interest on the strike price. If you exercise you lose insurance value of the option (the time premium) Real Options The application of derivatives theory to the operation and valuation of real investment projects A call option is the right to pay a strike price to receive the present value of a stream of future cash flows An investment project is the right to pay an investment cost to receive the present value of a future cash flow stream Investment Project = Call Option Investment Cost = Strike Price Present Value of Project = Price of Underlying Asset Consider an investment that requires an initial investment of \$100 today. The investment does not produce any cash payouts. However, after 2 years, you learn about the market for your product. At year 2, based on information obtained, you can invest \$1000 in a project or not. Currently, viewed from year 2, the expected present value of revenues is estimated to be \$1200. But there is much uncertainty about this number. This is in contrast to the fixed costs of \$1000 which is certain. Assume the riskless discount rate is 2% continuously compounded, and that the appropriate discount rate for the expected cash flows generated by the risky project is 8% continuously compounded. Further assume the volatility of the project is a little larger than the volatility of the stock market. Indeed , take the volatility to be 25% per year. Now conduct a traditional NPV analysis of this project. Traditional NPV NPV of Phase 1 = -100 NPV of Phase 2 = -1000e-2r + 1200e-2r* = 61.78 NPV of Project = -100 +61.78 = -\$38.22 Real Option Approach The first phase is an option that cost \$100. It gives you the right after two years to pay \$1000, and in return receive the PV of revenues from a project. Right now the expected revenues after 2 years are \$1200. The present value ( risk adjusted) of these revenues is \$1022.57. ( 1200e-0.08(2) ) But these revenues are uncertain. The volatility is 25% So we have S = 1022.57 X = 1000 T = 2 years r = 2% Sigma = 0.25 We can now price the call option ( \$172.17) Would you pay \$100 to receive something worth \$172.17 The adjusted NPV is \$72.17 Estimating the volatility is a bit difficult. But you could keep guessing a volatility until the value of the option equated the cost of the option. ( \$100). For this example, the breakeven volatility is 12% So if you believe the uncertainty in revenue exceeds 12%, then this is a good opportunity. The underlying tree is based off the revenue stream of the successful FINAL project. We start at the end of the tree and compute the option payoffs assuming we are still in the game We then use backward recursion until we get to a decision date. ( 8 periods earlier) At these nodes we ask the question. Is it worth paying the strike price, to receive the value of a claim at this node If the answer is yes, shade in the node ( blue) and write down the value of the option. If the answer is no, abandon and write down zero at that node. Continue the backward recursion until the next decision date. CORPORATE SECURITIES Problem 1 A firm has assets of \$100m. The volatility of the assets is 30%. The risk free rate is 6%, continuously compounded. The firm makes no payouts prior to the maturity date of the debt. The firm has a single debt issue with a maturity value of \$120m. (a)Compute the value of the debt today, if the issue matures in 1 year. (b)Compute the continuously compounded yield to maturity of this bond. (c)Compute the debt to equity ratio. (d) Repeat (a) and (b) under the assumption that the issue matures in 4 years. (e)Compute the debt to equity ratio again, and contrast this number to the number you obtained in (c). Solution (a)We use the Black Scholes formula to compute the price of the equity. A = 100, X=120, T = 1, sigma = 0.3, r = 0.06. Using BS, we obtain Equity= 7.23m. Hence the market price of the debt would be 92.77m (b) Yield = -LN(price/facevalue)/T = -Ln(92.77/120)/1 = 0.2574, or 25.74% (c)Debt/Equity ratio = 92.77/7.23 = 12.31

(d)We use the Black Scholes formula to compute the price of the equity. A = 100, X=120, T = 4, sigma = 0.3, r = 0.06. Using BS, we obtain Equity= 25.83m. Hence the market price of the debt would be 74.17m. The yield would be 12.03% (e)Debt/Equity ratio = 2.8715. It is much lower. The firm has more time to pay back the face value. This reduces the value of the debt today, lowering the debt to equity ratio Assume there are 20 shares outstanding. European warrants exist for 2 shares that expire in 5 years and have a strike price of \$15. The volatility is 30% and riskless rates are 6%, and the stock trades at 20 Solution The number of shares = n = 20. The number of warrants = m = 2. The dilution factor is n/(n+m) = 20/22. So the price of each warrant is reduced by 20/22 of the value of an otherwise identical European call option. W = (20/22)C = 20/22(9.14)=8.31

computed as the asset values less the callable bond values. I have only indicated the revised equity value at the root of the tree. ( 64.21)

The equity values are shown in red (second numbers in the lattice). They are obtained as call options on the assets of the firm (c)Value the debt of the firm at each node in the lattice over the three years. Value of the debt today = 100 61.28 = 38.715 Value of debt at each node is obtained by subtracting the second number ( equity) from the top number ( asset value) in each node of the lattice. They are indicated as the green numbers (third numbers in each node)

Problem 3 A firm has assets of 100m. The volatility of the assets is 30%. The riskless rate is 10% continuously compounded. (a) Set up a binomial lattice for the assets of the firm for three years. (b) Compute the risk neutral probability. (c) Assume a three year zero coupon bond exists with face value 60m. Compute the value of the equity at each node of the lattice. (d) What is the current value of the bond, and what is the continuously compounded credit spread. (e) Assume a two year call option existed on the stock with strike price 15. Compute its price.

(d)Assume a two year call option exists on the risky debt. The strike price of the call option on the bond is 42. Compute the price of the call option. The call options on the bond are indicated by the blue values. ( fourth numbers in the lattice) Starting in year 2 we can compute the final values of the call option. Max(bond price-42,0). Then use backward recursion (e)Assume the firm issued a callable bond instead of a straight bond. The terms of the call option are in (d). That is the firm retains the right to retire the debt at 42 dollars in the first two years. What would be the price of the callable bonds, and what would the equity price be. The price of the callable bond would be equal to the price of a straight bond minus the price of the call option on the bond. That is 35.79. Since the callable bond is cheaper than the straight bond, the equity price would be 100- 39.79= 64.21. (f)Explain why the callable bonds are cheaper than the otherwise equivalent callable bonds. The callable bond is cheaper because the owner of the callable bond has limited upside potential. Specifically, if the price exceeds the strike of 42 after 2 years, the firm will exercise its right to call the debt. (g)Also explain when the call option would be exercised. Can you tell today exactly when the maturity date is for the callable bond? In this problem the call option will be exercised in year 2 for sure. The reason is that regardless of the path of prices, the call option will expire in the money, making it certain that the call would be exercised. Notice, that in this problem the debt is free of risk. The holder of the non-callable debt is guaranteed to receive \$50 regardless of the path of asset values. And the callable bonds are effectively two year bonds with face value 42, since regardless of the path 42 dollars will be paid out in two years. So the straight bond should have a zero credit spread ( and it does 50/R3 = 38.715) And the callable bond in this example is a two year straight bond with no credit risk ( 42/R2 = 35.79) If the firm had a lower asset value, or if the face value of the debt was higher than it may be uncertain if the call would be exercised. In this case the effective maturity date of the bond would be uncertain. It could be two years or three years. And the callable bond price might deviate from a riskless bond price. You may want to redo this problem with a much higher level of debt! BINOMIAL MODEL A stock trades at 50. It can appreciate by 30% ( u =1.3) or depreciate by 20% ( d = 0.8). The riskless rate of return over the period is 10%, continuously compounded. (a) Compute the risk neutral probability (b) Compute the price of a call option with strike 50. (c ) Compute the replicating portfolio. R = exp(r) = exp(0.10) = 1.10517, p =(R-d)/(u-d); E = p15+(1-p)0; and C= E(C )/R. The calculations are below, Once you have C you can compute H as swing of call/swing of stock = (15-0)/(65-40) = 0.6; Recall C = HS-B;So to compute B we use B = HS-C= 21.7161.

The black (top) values are the values of the underlying. The second (red) values are the values of the two year call option which in this case represents the equity value. So, in this case, the value of the equity at date 0 is 50.9289. Now use the stock prices for the first two years as the main lattice. At the expiry date, we can compute the price of the call option with strike 15. These values are shown in green ( third values). We can work backwards, to compute the price of the call option on the equity. This value is 39.876 The current value of the bond is 100-50.93 = 49.07. Here we are assuming that there is only one share of stock traded! So all the prices are in millions. If there were one million shares outstanding, then the units of prices would be in dollars! This example illustrates how the binomial lattice can be used to price options on options on options. For example we could now price a one year put option on the (green) call option. If the strike price was 50, then the payout would be zero in the up-node and 50-14.617 in the down-node. Once these boundary values are known, we can work backwards to find the price today, using the usual risk neutral probabilities. Just out of interest, why might a speculator want to buy a put option on the call? ( Obviously, the speculator thinks the call price will drop after one year!) Hence the value of the equity is 335,847, and the value of the debt is 664,153 Jared Lazarus has just been named the new chief executive officer of BluBell Fitness Centers, Inc. In addition to an annual salary of \$500,000, his three-year contract states that his compensation will include 10,000 at-the-money European call options on the companys stock that expire in three years. Blubells current stock price is \$30 per share, and the annual variance of the continuously compounded returns on the firms stock is 0.1225. Blubell pays no dividends. Treasury bills that mature in three years yield a continuously compounded interest rate of 5 percent per annum. Assume that Jareds annual salary payments occur at the end of the year and that these cash flows should be discounted at a rate of 10 percent per annum. Using the Black-Scholes model to calculate the value of the stock options, determine the total value of Jareds compensation package on the date the contract is signed.

Assume that the firm has assets worth A = \$100, and that = 30%, r = 8%, and the firm makes no payouts prior to the maturity date of the debt. There are four debt issues with different priorities, each promising \$30 at maturity. Compute the yield on each debt issue assuming that all four mature in 5 years.

The replicating portfolio consists of going long 0.6 shares of stock partially financed by borrowing \$21.72 Use a two period binomial lattice to price an at the money call option. The Time to Expiration is 1 year. In each period (of six months) the stock can appreciate by u= 1.23611, or depreciate to d= 0.808858 of its value. (a)Construct the stock price lattice, given the initial price is 100. (b)Assume the continuously compounded riskless rate is 10% per year. Compute the riskless rate for each six month period, and establish the discount factor, R. (c)Compute the risk neutral probability (d)Price the two period at the money call option. Show the lattice of prices Given u and d the lattice of prices is below. 152.8465 52.84652 123.6311 28.50817 100 100 15.37879 0 80.88579 0 65.42511 0 If two up jumps occur the price increases to 152.8465 ; If a down jump is followed by an up jump the price returns to 100, etc. R = exp(0.5r) = 1.05127 P= (R-d)/(u-d)=0.56711 The strike, X=100. So we can compute the expiry date value of the call option at each node. When the stock is 152.8465, the option will be worth 52.8465. ( Why?). At the middle and low node the option expires worthless. ( Why?) We now work backwards. First consider the node where the stock price is 123.63. To compute the option value we compute C= [p(52.84652)+(1-p)0]/R = 28.50. Notice that the exercise value at this node is 23.6311, a lower value. The reason for this is that the time premium for a call option will be positive. You would never exercise a call option on a non dividend paying stock early. When the stock is 80.88, the option is worthless. (why?) Now go back to date 0. The price of the call is [p28.50 +91-p)0]/R = 15.378. This is the answer. Again, notice that the exercise value is 0, so the full value of the option is based on its time premium. Once you have the call price lattice values, it is easy to compute the replicating portfolio values . Consider doing this at date 0. The first step is to compute H. To do this we compute the swing in option prices/swing in stock prices. That is, H = (28.508-0)/(123.63-80.8857) = 0.666931. Once you have that number then the Borrowing is HS-C = 0.666931(100)-15.3789 = 51.31428 dollars So the replicating strategy for the call is to start with 15.378 dollars, borrow 51.314 dollars and use all the proceeds ( \$66.69) to purchase 0.6669 shares of stock. As you can see this option has the risk of a very leveraged position in the stock. Indeed the leverage ratio is (money invested)/initial investment= 66.69/15.378 = 4.337. ( HS/C)

In summary we can price call options with increasing strike prices. We then can compute the equity price as a call option. Then the most junior debt can be called as a spread option. The less junior debt can be priced; then the most senior debt Assume a firm has assets worth \$100, and that = 30%, r = 8%, and the firm makes no payouts prior to the maturity date of the debt. (a)Construct a binomial lattice with three periods, representing asset values over each year. (b)Value the equity of the firm assuming that there exists a three year zero coupon bond with face value 50. In this lattice I have placed ( at each node) many bits of information. The top number is the asset value; then the equity value ( equity as a call) Then the straight bond value. The next numbers are the option values and the callable bond values. If a firm issued callable debt, then the equity values would be

In this problem, the underlying never pays a dividend, so early exercise of the call option is never optimal. If there was a dividend yield, then the p value will be a bit lower and the call values will be reduced. In this case early exercise could be optimal. See the next example. Reconsider Problem 2, but this time assume the dividend yield is 9% per year. Solution In this case the price lattice for the stock remains unchanged. However the risk neutral probability value is reduced. In particular P = ( e(r-q)dt-d)/(u-d), where r=0.10, q=0.09 and dt =0.5. P = 0.458891 The terminal values of the call option remain unchanged. Now consider the node where the stock is 123.63 We first compute the value of the option unexercised. This value is [p(52.84)+91-p)0]/R = 23.06 However, if we exercise the option at this node we get 123.63-100 = 23.63. So it is optimal to exercise at this node. The value of the option at this node is 23.63. At date 0, the value unexercised is 10.31. The value exercised is 0, so we do not exercise here. Note in this example, the value of the option is lower than when dividends are not present. This will always be the case. Reconsider Problem 3. However, here we are given the volatility of the stock is 30% per year. Solution To set up a 2 period binomial lattice we need u and d. The formula for u is =1.236, Then d=1/u = 0.808

\$108.33, Maverick should borrow the present value of \$108.33 now. In three months, the firm must pay \$108.33, which will decrease its payoffs so that they exactly match those of an actual call option. Maverick should buy 1/3 of an ounce of gold and borrow \$104.17 [= \$108.33 / (1.1699)1/4] in order to create a synthetic call option with a strike price of \$375 and 3 months until expiration. d..Since Maverick pays \$116.67 in order to purchase gold and borrows \$104.17, the total cost of the synthetic call option is \$12.50 (= \$116.67 \$104.17). This is exactly the same price that Maverick would pay for an actual call option. Since an actual call option and a synthetic call option provide Maverick with identical payoff structures, the firm should not expect to pay more for one than the other. Greeks Delta: option price / stock price option price = call = N(d1) put = N(d1) 1 Delta is the price exposure of the option to moves in the underlying security. If Delta = 0.3 Call long gain 0.3 if the stock goes up by \$1 Short call lose 0.3 if the stock increases by \$1 oAt the money call options have delta values close to 0.5 oAs the stock increases in price the option eventually moves one for one with the stock and its delta increases to 1. The net exposure of a position in many options on the same stock can be determined by adding up the delta values of each option in the position. Delta Neutral = Immunizing strategy. You can immunize your position either buying/selling stocks according to the value of the delta or if a portfolio of options is given by setting the equation: N of option A (given) * Delta option A + (or -) n of option B * delta option B Dynamic strategies: Delta value depends on the stock price and time to expiration, it does not remain constant and the immunized position will soon be exposed to risk. After one week even if the stock price stays the same, the delta value of the option, computed Black Scholes (N(d1)) with a time to expiration reduced by one week would change and less shares would be held to maintain an immunized position. Hence, to maintain hedge, position must be adjusted continuously. Gamma: in delta / dollar change in stock price. It measures the rate of change in the delta of the option position as the underlying price changes. If an option has a small gamma value, it means that the options delta value is relatively stable and can better hedge a large price change in the underlying stock than if the option had a large gamma value. If gamma = 0, it does not face convexity risk (option deeply out of money. The gamma value for a position are like the delta values, in that they are additive. The gamma of a call with strike is A this means that if the stock changes by \$1 the delta of the option will increase by A. Delta & Gamma of a stock = 0 Positive Gamma = position benefit from the price move (if large) Negative Gamma = position will lose money if price move (if large) Positive gamma positions with positive deltas have the property that the change in the value of the position with favorable price moves will be greater than with negative price moves. Theta: dollar change in option price / decrease in time to expiration it measures the dollar change in the option price per unit decrease in the time to expiration assuming the stock price remains unchanged. Theta value for call options on nondividend stock is always negative. Stock option with large negative theta can loose their time premium rapidly. The value changes the most as maturity approaches. Put options usually have negative thetas as well. You cant increase Gamma and Theta at the same time or indeed keeping it the same. As a results, among delta neutral strategies, there always be a trade-off between theta risk and gamma risk. Vega: Change in Option price / 1% change in volatility. As volatility expand, the price of most options expand. Vega measure the dollar change in the value of the option when the underlying volatility changes by 1%. An investor that has positive vega position is said to be long volatility, and will benefit if volatility increases. Similarly, an investor has sold volatility or is short volatility if the vega of the position is negative. Always think to= N of option contracts * number of shares per option contract Theta, divide theta per 52, per ottenere theta x week. Poi sottrai o aggiungi all option price. Moltiplica infine per number of shares per contract and number of option contracts. Volatility= in volatility a intervally di 1% * Vega * option contracts * number of shares per contract. 1. Calculate all the Greeks for the portfolio 2. Calculated using the value provided opposite range. 3. Multiply the value obtained by subtracting the old delta of the delta. Here you go short. 1. A stock is priced at \$30. The volatility of the stock is 25% per year, and the riskless interest rate is 7%. A 3 month European call option with a strike price of 25 trades at its Black Scholes price of \$5.51.

B = HS - C = 0.71 48 - 9.88 = \$24.2 f) = e = HS/C=071(48)/(9.88) = 3.449 That is, for each percentage change in stock price the call price changes by 3.449% g) c = S = 3.449 1.30 = 4.4837 c = s = 3.449 0.36 = 124.2% 3 Information on 3 month at the money European options which has a volatility of 30% a year are shown below. The current stock price is 20.

e) Compute the share equivalents for the position in (d). Compute the net Borrowing and the leverage. We set up two equations in two unknowns a) 0.576 Nc - 0.424 Np = 0 3.92 Nc + 3.92 Np = 4.04 Solving these two equations we obtain Nc= 0.4370; Np = 0.5937 So the trader needs to purchase 0.437 calls and 0.5937 puts.

Maverick Manufacturing, Inc., must purchase gold in three months to use in its operations. Maverick management has estimated that if the price of gold were to rise above \$375 per ounce, the firm would go bankrupt. The current price of gold is \$350 per ounce. The firms chief financial officer believes that the price of gold will either rise to \$400 per ounce or fall to \$325 per ounce over the next three months. Management wishes to eliminate any risk of the firm going bankrupt. Maverick can borrow and lend at the risk-free interest rate of 16.99 percent per annum (effective annual yield). a.Would Maverick be interested in buying a call option or a put option on the price of gold? In order to avoid bankruptcy, what strike price and time to expiration would the firm like this option to have? b.How much should such an option sell for in the open market? c.If no options currently trade on gold, is there a way for Maverick to create a synthetic option with identical payoffs to the option described above? If there is, how would the firm do it? d.How much does the synthetic option cost? Is this greater than, less than, or equal to what the actual option costs? Does this make sense? Solution a. Maverick would be interested in purchasing a call option on the price of gold with a strike price of \$375 per ounce and 3 months until expiration. This option will compensate Maverick for any increases in the price of gold above the strike price and places a cap on the amount the firm must pay for gold at \$375 per ounce. b.In order to solve a problem using the two-state option model, first draw a price tree containing both the current price of the underlying asset and the underlying assets possible values at the time of the options expiration. Next, draw a similar tree for the option, designating what its value will be at expiration given either of the 2 possible stock price movements. The price of gold is \$350 per ounce today. If the price rises to \$400, Maverick will exercise its call option for \$375 and receive a payoff of \$25 at expiration. If the price of gold falls to \$325, Maverick will not exercise its call option, and the firm will receive no payoff at expiration

If the price of gold rises, its return over the period is 14.29% [= (400/350) 1]. If the price of gold falls, its return over the period is -7.14% [= (325/350) 1]. Use the following expression to determine the risk-neutral probability of a rise in the price of gold: Risk-Free Rate = (ProbabilityRise)(ReturnRise) + (ProbabilityFall)(ReturnFall) = (ProbabilityRise)(ReturnRise) + (1 - ProbabilityRise)(ReturnFall) To match the data given, the strike of the call should be \$25. a) P(0) = 5.51 - 30 + 25exp(-0.070.25) = \$0.077 b) The delta value is 0.952. This means the number of share equivalents is 0.952. The leverage value is given by = HS/C = 0.952(30)/5.51 = 5.18 That is, if the stock increases by 1%, the option is expected to change by 5.18%. c) The delta of a put is p = c - 1 = - 0.048 The option is equivalent to a short position in 0.048 shares. The leverage is = -0.048(30)/0.077 = -18.7 That is, if the stock increases by 1% the option decreases by 18.7%. d) 100 call options controls 100 100 = 10,000 shares. Since the delta value is 0.952, the trader need purchase 9,520 shares to be locally immunized. e) If the stock price moves \$1, then the delta value will increase from its old value to a new value which is higher (i.e. delta will increase by 0.0268). Cnew = Cold + 2 + = 5.51 + 2(0.952) + 0.0268 As the stock price increases, the trader needs to purchase stocks at a rate of to maintain the immunization. U=e^(sigma*sqrt delta t) P=(R-d)/(U-d)

The risk-free rate over the next three months must be used in the order to match the timing of the expected price change. Since the risk-free rate per annum is 16.99%, the risk-free rate over the next three months is 4% [= (1.1699)1/4 1]. 0.04 ProbabilityRise ProbabilityFall = (ProbabilityRise)(0.1429) + (1 ProbabilityRise)(-0.0714) = 0.5198 = 1 - ProbabilityRise = 1 0.5198 = 0.4802

The risk-neutral probability of a rise in the price of gold is 51.98%, and the risk-neutral probability of a fall in the price of gold is 48.02%. Using these risk-neutral probabilities, determine the expected payoff to Mavericks call option at expiration. Expected Payoff at Expiration = (.5198)(\$25) + (.4802)(\$0) = \$13.00 Since this payoff occurs 3 months from now, it must be discounted at the risk-free rate of 16.99% per annum in order to find its present value: PV(Expected Payoff at Expiration) = [\$13.00 / (1.1699)1/4 ] = \$12.50 Therefore, given the information Maverick has about golds price movements over the next three months, a European call option with a strike price of \$375 and three months until expiration is worth \$12.50 today. b.Yes, there is a way for Maverick to create a synthetic call option with identical payoffs to the call option described above. In order to do this, Maverick will need to buy gold and borrow at the risk-free rate. The amount of gold that Maverick should buy is based on the delta of the option, where delta is defined as: Delta = (Swing of option) / (Swing of price of gold) Since the call option will be worth \$25 if the price of gold rises and \$0 if it falls, the swing of the call option is 25 (= 25 0). Since the price of gold will either be \$400 or \$325 at the time of the options expiration, the swing of the price of gold is 75 (= 400 - 325). Given this information: Delta = (Swing of option) / (Swing of price of gold) = (25 / 75) = 1/3 Therefore, Mavericks first step in creating a synthetic call option is to buy 1/3 of an ounce of gold. Since gold currently sells for \$350 per ounce, Maverick must pay \$116.67 (= 1/3 * \$350) to purchase 1/3 of an ounce of gold. In order to determine the amount that Maverick should borrow, compare the payoff of the actual call option to the payoff of delta shares at expiration. Call Option If the price of If the price of Delta Shares If the price of If the price of

gold rises to \$400: gold falls to \$325: gold rises to \$400: gold falls to \$325:

## payoff = \$25 payoff = \$0 payoff = (1/3)(\$400) = \$133.33 payoff = (1/3)(\$325) = \$108.33

Maverick would like the payoff of his synthetic call position to be identical to the payoff of an actual call option. However, buying 1/3 of a share leaves him exactly \$108.33 above the payoff at expiration, regardless of whether the price of gold rises or falls. In order to decrease the firms payoff at expiration by

2. S0 = \$48, = 36%, r = 7%, X = \$45 a) \$9.88100 = \$988 b) expected drop in one week: -\$4.65/52 = -\$0.089423 50 100 \$(9.88 - 0.089423) = \$48,952.885 c) Price change = 0.04 16.43 50 100 = \$3,286 d) Dollar gain = 0.005 24.2 200 100 = \$2,420 e) Share equivalents is 0.71