Review Guide for Midterm Exam 1 of BUS 172C

This guide has a limited amount of information for Midterm exam 1.

 Meanings of call, put, American-style, European-style options, strike price of a call

option, strike price of a put option

 Does written put imply a long or short position in underlying market?

 What is Put-call parity (P-C P)?

 Application of P-C P: GS, Inc. stock is selling for $28 a share. A 3-month call on GS stock
with a strike price of $30 is priced at $1.50. Risk-free assets are currently returning 0.3%
per month. What is the price of a 3-month put on GS stock with a strike price of
$30? : (Hint: use the Put-call parity)
Solution: Determining a put option price. You see that stock price (S0=$28), the
same strike price ($30) and the call option price ($1.5) with the same time to
expiration (3 month). Hence, you can sense that it is about the put-call parity. By
the put call parity,

𝑃0 = 𝐶0 − 𝑆0 + 𝐾𝑒 −𝑟𝑇
= 1.5 – 28 + 30𝑒 −0.003×3 = $3.23

 Synthetic positions driven from P-C P.

Example
What is the synthetic position for short call?
What is the synthetic position for long put?

 Factors that affect the stock options

More information is below.

Topic Reader Participation Quiz

Page paper *Solution
guide
Calculation of profit/loss for long position with 19
no exercise
Calculation of profit/loss for long position with 20 #1 (5)
exercise
Calculation of profit/loss for short (written) #3 #1 (6)
position
Calculation of call option price (or put option 24 #1 (2)
price) using the put-call parity
*Another example in the later page of this
guide.
Composition of an option value 11, 13, #1 (10)
14, 15
Example given a call option price $5, spot price of $56 and strike price of $54, determine
the intrinsic value and time value.
One-step binomial (European) 42, 43 #2 (2) (3)
*For American one-step binomial, just check
whether the exercise value is greater than the
binomial theoretical value, if so, then the option
value is the exercise value. (we have seen this in
the two-step models)
Value of N( ) in the Black-Scholes model 58 #3 (1) (2)
With
lecture
Black-Scholes model 59 #3 (3) (7)
Value of equity and bonds using the Black- 76, 78, 80 #3 (8)
Scholes model
 Participation paper #3

Example: An investor is speculating on Apple stock over the next three months. The current Apple
stock price is $93.5. She shorted 5 call option contracts of AAPL with the strike price of $94. The
price of a call option on AAPL is $ 3.20.

1) Is she expecting the increase of decrease in Apple stock price?

2) What is the breakeven stock price for the position?
3) How much is the total up-front option cost to enter into the contracts?
4) Consider two possible cases where the stock price becomes $88 or $100 in three
months at maturity, respectively. Assume option buyers exercise options when
exercisable. What are the profits of the option position for the option writers?
--- Solution ---
(1) Expected to decrease. Why since she shorted call options. Recall that the long call gains
when price rises. The short call gains when price falls.
(2) If net profit (NP)= 0, then breakeven. Hence, the NP per one option for calls = S – K – C.
Since K=94 and C = 3.2, the NP will be S – 97.2, which will be zero if Spot price (S) =
$97.2 (solution)
(3) Total up-front cost = size *option price*number of contract = 100*$3.2*5 = $1,600
(Solution).
(4) If the spot price became $100, then the call option buyers will exercise. Then the profit
of call option buyers will be = size*(Max(S – K,0) – C)*number of contract =
100*(max(100-94,0) – 3.2)*5=500*(6-3.2)=$1,400. Hence, the profit of call option writer
= - profit of call option buyers = -$1,400 loss (solution).
If the spot price became $88, then the call option buyers will NOT exercise (why” S < K
for calls  No exercise). Then the profit of call option buyers will be = size*(Max(S – K,0)
– C)*number of contract = 100*(max(88-94,0) – 3.2)*5=500*(0-3.2)= - $1,600. Hence,
the profit of call option writer = - profit of call option buyers = + $1,600 profit (solution).
Equity valuation using Black-Scholes option pricing