BFC2751 - Tutorial 5

Mechanics of Options Markets - Stock Option Properties

***Question 1

(Hull – Q 8.9 and 8.10)

a. Suppose that a European call option to buy a share for $100 cost $5 and is held until maturity. Under
what circumstances will the holder of the option make a profit? Under what circumstances will the
option be exercised? Draw a diagram illustrating how the profit from a long position in the option
depends on the stock price at maturity of the option.

b. Suppose that a European put option to sell a share for $60 cost $8 and is held until maturity. Under
what circumstances will the seller of the option make a profit? Under what circumstances will the
option be exercised? Draw a diagram illustrating how the profit from a short position in the option
depends on the stock price at maturity of the option.
Self-Study Questions:

Question 2

Determine whether each of the following arrangements is an option. If so, is it a call or a put? Also,
identify the premium:

(i) Buying house insurance.

(ii) Entering a long-term house lease that cannot be cancelled.

(a) Explain the difference between an American option and a European option. What do
they have in common?
(b) Compare and contrast the exercise procedure for stock options with that for index
options. What major advantage does exercising an index option have over exercising a
stock option?
(c) Discuss the three possible ways in which an option position can be terminated. Would
your answer be different if the option was created in an OTC market?
(d) Name and briefly describe two other instruments that are very similar to options.

Question 3

Volatility is attractive to option holders, call and put alike. Why?

Question 4

A one-month European put option on a non-dividend-paying stock is selling for $2.50. The stock
price is $47, the strike price is $50, and the risk-free interest rate is 6 percent per annum. What
opportunities are there for an arbitrageur?

Question 5

It is not optimal to exercise early American call options on non-dividend paying stocks. Explain why
this statement is true. Does the statement apply to put options as well?

Question 6

Consider the following two portfolios.

Portfolio A: 1 European call option

Cash=Ke-rT (= Present value of the exercise price)

Portfolio B: 1 European put option

1 share

(a) Show the present value and future value of these two portfolios in a table.

(b) Derive the put-call parity for European options from your analysis in part (a).