MT3470: Solutions to Problem Set 2

1. Suppose you write a put option on an underlying asset with a strike price of £115 and maturity
6 months that costs P = £5. What have you committed yourself to? How much could you
gain or lose? Explain briefly.
Solution.
Committed to buying the asset for 115 in 6 months time, should the option holder choose to
exercise the option then.
Your payoff is − max(115 − S, 0), and the net profit is 5 − max(115 − S, 0).
You could lose the difference (115 − S), if the underlying price in 6 months time is S < 115. In
return for the possible future losses, you have received the option premium P = £5 from the
purchaser. [20]

2. Suppose that a put option with strike price £50 costs £4. What is a payoff of the seller of
the option at maturity? Under what circumstances will the seller of the option make a profit?
Explain briefly.
Solution.
The payoff of the option writer/seller (ignoring the initial outlay to acquire the option) is
V (S) = −(50 − S)+ . It is negative if the share price S = S(T ) at maturity T does not exceed
£50. The payoff is zero, if S(T ) > £50.
If we take the initial outlay into account, then the option seller makes a net profit if S >
50 − 4 = 46, the maximal profit is £4 (if S ≥ 50). [20]

3. What is the difference between entering into a long forward contract when the delivery price
is 50 and taking a long position in a call option with strike price of 50? Explain briefly.
Solution.
The holder of the long forward position is obliged to buy the asset for 50 and does not have a
choice.
The holder of the long call has the right to buy the asset for 50 but does not have to exercise
this right. [20]

4. A share is currently traded at S(0) = £60. A European call on the share with a strike of £58
and expiry in three months trades at C = £3. The risk-free rate is r = 5%. A European put
on the share is offered on the market, with the same strike and expiry, for P = £1.5. Do any
arbitrage opportunities exist? If so, construct a strategy to take advantage of it.
Solution.
The put and the call should satisfy put-call parity, which can be written as follows

C + Ke−rT = P + S.

Here we have got

C + Ke−rT = 3 + 58e−0.05×1/4 = 3 + 57.2795 = 60.2795 < P + S = 1.5 + 60 = 61.5

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This suggests the following arbitrage strategy.
At t = 0 short the put and the asset and this gives 61.5. Buy the call and invest 61.5 − 3 = 58.5
risk free for three months.
At time t = 1/4 = 0.25 (which is three months in years), receive 58.5e0.05/4 = 59.2358 from the
risk free investment.
If S(0.25) < 58, then the call is worthless, but the put will be exercised by its holder, so
have to buy the asset for 58 and thus close out the short position. The amount left, i.e.
59.2358 − 58 = 1.2358 is the risk-free profit.
If S(0.25) ≥ 58, then the put will not be exercised, exercise the call and buy the asset for 58,
and, as above, close out the short position. The amount left, i.e. 59.2358 − 58 = 1.2358 is the
risk-free profit. [20]

One can also proceed as follows to construct the arbitrage strategy.

The put and the call should satisfy put-call parity, which can be written as follows

C − P = S − Ke−rT .

Here we have got C − P = 3 − 1.5 = 1.5. This should be equal to

S − Ke−rτ = 60 − 58e−0.05×1/4 = 2.72

which it clearly isn’t. To construct the arbitrage strategy we consider two portfolios

• Portfolio M1 : the long call and the short put; the portfolio value at t = 0 is C − P = 1.5,
value at expiry is max(S(T ) − 58, 0) − max(58 − S(T ), 0) = S(T ) − 58.
• Portfolio M2 : 1 unit of the underlying and amount of cash Ke−rτ = 57.28 borrowed at
the risk-free rate; cost is 60 − 57.28 = 2.72. At expiry, we sell the underlying at S(T ) and
repay the borrowed amount including interest, i.e. 58, giving a net profit of S(T ) − 58.

The principle is the same: sell what is overpriced and buy what is undervalued. Here: short
sell M2 and buy portfolio M1 , this yields a risk-free profit of 2.72 − 1.5 = 1.22. In more detail,
this is what we do:

• go short in the put, i.e. borrow the put from a broker and sell it for 1.5;
• go short in the underlying, i.e. borrow it from the broker and sell it for 60;
• buy the call for 3;
• of the remaining 61.5-3=58.5, put 57.28 in cash in a savings account at the risk-free rate.

We can keep the remaining 1.22 as profit, because at expiry we can clear our position. Let’s
see how. In case the stock ended up below 58:

• we empty the savings account, which now contains 58;

• the call is worthless, so nothing needs to be done there;
• the broker from whom we borrowed the put needs to be repaid with the put’s payoff
58 − S(T );

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 • that same broker needs to be repaid with the underlying’s current value S(T ); in total,
we repay him 58.

Indeed, no extra money is needed to do this.

If the stock ended up above 58:

• we empty the savings account, which now contains 58;

• the put is worthless, so nothing needs to be done there;
• the broker needs to be repaid with the underlying’s current value S(T ); in total, we repay
him S(T );
• as the holder of the call will have exercised we need to sell him the stock at 58, so we buy
the stock from the open market, at the current price S(T ), and get 58 from the holder.

Again, no extra money is needed.

5. A straddle is a combination of a long call and a long put, both on the same asset, with the
same maturity and the same strike. Consider a straddle on a certain asset, with strike £100,
such that the price of the call is C = £11 and the price of the put is P = £9.
a) What values of the underlying asset will return a positive profit at maturity?
b) Replace the put option in the straddle by another put option with strike K < £100. Is the
new combination more expensive than the straddle?
Solution.
a) The straddle always pays off. Indeed, if S(T ) > K = 100, then the call option pays off
S(T ) − 100 (the put is worthless); if S(T ) ≤ K = 100, then the put option pays off 100 − S(T )
(the call is worthless).
A positive profit is obtained, when either S(T ) − 100 − (11 + 9) > 0, i.e. S(T ) > 120, or
100 − S(T ) − (9 + 11) > 0, i.e. S(T ) < 80.
b) The price of the new portfolio (combination of the new put and the old call) is equal to
11 + Pnew , where 11 is the price of the call and Pnew is the price of the put with strike K.
Since K < 100, the new put option is cheaper than then the old put.
Therefore, the new combination of options is cheaper than the straddle. [20]