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**MFE and CAS Exam 3 FE
**

Yufeng Guo

March 28, 2010

Contents

Introduction vii

9 Parity and other option relationships 1

10 Binomial option pricing I 23

11 Binomial option pricing II 91

12 Black-Scholes formula 107

13 Market making and delta hedging 125

14 Exotic options: I 149

18 Lognormal distribution 161

19 Monte Carlo simulation 177

20 Brownian motion and Ito’s lemma 187

21 The Black-Scholes equation 193

22 Exotic options: II 203

23 Volatility 205

24 Interest rate models 209

iii

Preface

This is Guo’s solution to Derivatives Markets (2nd edition ISBN 0-321-28030-X)

for SOA MFE or CAS Exam 3 FE. Unlike the oﬃcial solution manual published

by Addison-Wesley, this solution manual provides solutions to both the even-

numbered and odd-numbered problems for the chapters that are on the SOA

Exam MFE and CAS Exam 3 FE syllabus. Problems that are out of the scope

of the SOA Exam MFE and CAS Exam 3 FE syllabus are excluded.

Please report any errors to yufeng.guo.actuary@gmail.com.

This book is the exclusive property of Yufeng Guo. Redistribution of this

book in any form is prohibited.

v

Introduction

Recommendations on using this solution manual:

1. Obviously, you’ll need to buy Derivatives Markets (2nd edition) to see the

problems.

2. Make sure you download the textbook errata from http://www.kellogg.

northwestern.edu/faculty/mcdonald/htm/typos2e_01.html

vii

Chapter 9

Parity and other option

relationships

Problem 9.1.

o

0

= 32 T = 6´12 = 0.5 1 = 35

C = 2.27 r = 0.04 c = 0.06

C +1\ (1) = 1 +o

0

c

−oT

2.27 + 35c

−0.04(0.5)

= 1 + 32c

−0.06(0.5)

1 = 5. 522 7

Problem 9.2.

o

0

= 32 T = 6´12 = 0.5 1 = 30

C = 4.29 1 = 2.64 r = 0.04

C +1\ (1) = 1 +o

0

−1\ (1i·)

4.29 + 30c

−0.04(0.5)

= 2.64 + 32 −1\ (1i·)

1\ (1i·) = 0.944

Problem 9.3.

o

0

= 800 r = 0.05 c = 0

T = 1 1 = 815 C = 75 1 = 45

a. Buy stock+ sell call+buy put=buy 1\ (1)

C +1\ (1) = 1 +o

0

→1\ (1 = 815) = o

0

|{z}

buy stock

+ −C

|{z}

sell call

+ 1

|{z}

buy put

= 800 + (−75) + 45 = 770

So the position is equivalent to depositing 770 in a savings account (or buy-

ing a bond with present value equal to 770) and receiving 815 one year later.

770c

1

= 815 1 = 0.056 8

1

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

So we earn 5.68%.

b. Buying a stock, selling a call, and buying a put is the same as depositing

1\ (1) in the savings account. As a result, we should just earn the risk free

interest rate r = 0.05. However, we actually earn 1 = 0.056 8 r. To arbitrage,

we "borrow low and earn high." We borrow 770 from a bank at 0.05%. We use

the borrowed 770 to ﬁnance buying a stock, selling a call, and buying a put.

Notice that the net cost of buying a stock, selling a call, and buying a put is

770.

One year later, we receive 770c

1

= 815. We pay the bank 770c

0.05

= 809.

48. Our proﬁt is 815 −809. 48 = 5. 52 per transaction.

If we do : such transactions, we’ll earn 5. 52: proﬁt.

Alternative answer: we can burrow at 5% (continuously compounding) and

lend at 5.6 8% (continuously compounding), earning a risk free 0.68%. So if

we borrow $1 at time zero, our risk free proﬁt at time one is c

0.0568

− c

0.05

=

0.00717 3; if we borrow $770 at time zero, our risk free proﬁt at time one is

0.00717 3×770 = 5. 52. If we borrow : dollars at time zero, we’ll earn 0.00717 3:

dollars at time one.

c. To avoid arbitrage, we need to have:

1\ (1 = 815) = o

0

|{z}

buy stock

+ −C

|{z}

sell call

+ 1

|{z}

buy put

= 815c

−0.05

= 775. 25

→C −1 = o

0

−1\ (1) = 800 −775. 25 = 24. 75

d. C −1 = o

0

−1\ (1) = 800 −1c

−:T

= 800 −1c

−0.05

If 1 = 780 C −1 = 800 −780c

−0.05

= 58. 041

If 1 = 800 C −1 = 800 −800c

−0.05

= 39. 016

If 1 = 820 C −1 = 800 −820c

−0.05

= 19. 992

If 1 = 840 C −1 = 800 −840c

−0.05

= 0.967

Problem 9.4.

To solve this type of problems, just use the standard put-call parity.

To avoid calculation errors, clearly identify the underlying asset.

The underlying asset is 1. We want to ﬁnd the dollar cost of a put option

on this underlying.

The typical put-call parity:

C +1\ (1) = 1 +o

0

c

−oT

C, 1, 1, and o

0

should all be expressed in dollars. o

0

is the current (dollar

price) of the underlying. So o

0

= $0.95.

C = $0.0571 1 = $0.93

c is the internal growth rate of the underlying asset (i.e. 1). Hence c = 0.04

Since 1 is expressed in dollars, 1\ (1) needs to be calculated using the

dollar risk free interest r = 0.06.

0.0571 + 0.93c

−0.06(1)

= 1 + 0.95c

−0.04(1)

1 = $0.02 02

www.actuary88.com c °Yufeng Guo 2

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Problem 9.5.

As I explained in my study guide, don’t bother memorizing the following

complex formula:

C

$

(r

0

. 1. T) = r

0

11

]

µ

1

r

0

.

1

1

. T

¶

Just use my approach to solve this type of problems.

Convert information to symbols:

The exchange rate is 95 yen per euro. 1 95 =1 or 1 1 =

1

95

Yen-denominated put on 1 euro with strike price Y100 has a premium Y8.763

→(1 →1 100)

0

=Y8.763

What’s the strike price of a euro-denominated call on 1 yen? 1 →11

Calculate the price of a euro-denominated call on 1 yen with strike price 1

(1 →11 )

0

= ?

1 →1 100 →

1

100

→1 1

The strike price of the corresponding euro-denominated yen call is 1 =

1

100

=0.01

µ

1

100

→1 1

¶

0

=

1

100

×(1 →1 100)

0

=

1

100

(1 8.763)

Since 1 1 =

1

95

, we have:

1

100

(1 8.763) =

1

100

(8.763)

µ

1

95

¶

=9. 224 2 ×10

−4

→

µ

1

100

→1 1

¶

0

=9. 224 2 ×10

−4

So the price of a euro-denominated call on 1 yen with strike price 1 =

1

100

is 9. 224 2 ×10

−4

www.actuary88.com c °Yufeng Guo 3

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Problem 9.6.

The underlying asset is 1. The standard put-call parity is:

C +1\ (1) = 1 +o

0

c

−oT

C, 1, 1, and o

0

should all be expressed in dollars. o

0

is the current (dollar

price) of the underlying.

c is the internal growth rate of the underlying asset (i.e. 1).

We’ll solve Part b ﬁrst.

b. 0.0404 + 0.9c

−0.05(0.5)

= 0.0141 +o

0

c

−0.035(0.5)

o

0

= $0.920 04

So the current price of the underlying (i.e. 1) is o

0

= $0.920 04. In other

words, the currency exchange rate is $0.920 04 =1

a. According to the textbook Equation 5.7, the forward price is:

1

0,T

= o

0

c

−oT

c

:T

= 0.920 04c

−0.035(0.5)

c

0.05(0.5)

= $0.926 97

Problem 9.7.

The underlying asset is one yen.

a. C +1c

−:T

= 1 +o

0

c

−oT

0.0006 + 0.009c

−0.05(1)

= 1 + 0.009c

−0.01(1)

0.0006 + 0.008561 = 1 + 0.008 91 1 = $0.00025

b. There are two puts out there. One is the synthetically created put using

the formula:

1 = C +1c

−:T

−o

0

c

−oT

The other is the put in the market selling for the price for $0.0004.

To arbitrage, build a put a low cost and sell it at a high price. At t = 0, we:

• Sell the expensive put for $0.0004

• Build a cheap put for $0.00025. To build a put, we buy a call, deposit

1c

−:T

in a savings account, and sell c

−oT

unit of Yen.

T = 1 T = 1

t = 0 o

T

< 0.009 o

T

≥ 0.009

Sell expensive put 0.0004 o

T

−0.009 0

Buy call −0.0006 0 o

T

−0.009

Deposit 1c

−:T

in savings −0.009c

−0.05(1)

0.009 0.009

Short sell c

−oT

unit of Yen 0.009c

−0.01(1)

o

T

o

T

Total $0.00015 0 0

0.0004 −0.0006 −0.009c

−0.05(1)

+ 0.009c

−0.01(1)

= $0.00015

www.actuary88.com c °Yufeng Guo 4

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

At t = 0, we receive $0.00015 yet we don’t incur any liabilities at T = 1 (so

we receive $0.00015 free money at t = 0).

c. At-the-money means 1 = o

0

(i.e. the strike price is equal to the current

exchange rate).

Dollar-denominated at-the-money yen call sells for $0.0006. To translate this

into symbols, notice that under the call option, the call holder can give $0.009

and get 1 1.

"Give $0.009 and get 1 1" is represented by ($0.009 →1 1). This option’s

premium at time zero is $0.0006. Hence we have:

($0.009 →1 1)

0

= $0.0006

We are asked to ﬁnd the yen denominated at the money call for $1. Here

the call holder can give c yen and get $1. "Give c yen and get $1" is represented

by (1 c →$1). This option’s premium at time zero is (1 c →$1)

0

.

First, we need to calculate c, the strike price of the yen denominated dollar

call. Since at time zero $0.009 = 1 1, we have $1 = 1

1

0.009

. So the at-the-

money yen denominated call on $1 is c =

1

0.009

. Our task is to ﬁnd this option’s

premium:

µ

1

1

0.009

→$1

¶

0

=?

We’ll ﬁnd the premium for 1 1 →$0.009, the option of "give 1 yen and get

$0.009." Once we ﬁnd this premium, we’ll scale it and ﬁnd the premium of "give

1

0.009

yen and get $1."

We’ll use the general put-call parity:

(¹

T

→1

T

)

0

+1\ (¹

T

) = (1

T

→¹

T

)

0

+1\ (1

T

)

($0.009 →1 1)

0

+1\ ($0.009) = (1 1 →$0.009)

0

+1\ (1 1)

1\ ($0.009) = $0.009c

−0.05(1)

Since we are discounting $0.009 at T = 1 to time zero, we use the dollar

interest rate 5%.

1\ (1 1) = $0.009c

−0.01(1)

If we discount Y1 from T = 1 to time zero, we get c

−0.01(1)

yen, which is

equal to $0.009c

−0.01(1)

.

So we have:

$0.0006+$0.009c

−0.05

= (1 1 →$0.009)

0

+ $0.009c

−0.01(1)

(1 1 →$0.009)

0

= $2. 506 16 ×10

−4

µ

1

0.009

1 1 →$1

¶

0

=

1

0.009

(1 1 →$0.009)

0

= $

2. 506 16 ×10

−4

0.009

= $2.

784 62 ×10

−2

= 1

2. 784 62 ×10

−2

0.009

= 1 3. 094

www.actuary88.com c °Yufeng Guo 5

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

So the yen denominated at the money call for $1 is worth $2. 784 62 ×10

−2

or 1 3. 094.

We are also asked to identify the relationship between the yen denominated

at the money call for $1 and the dollar-denominated yen put. The relationship

is that we use the premium of the latter option to calculate the premium of the

former option.

Next, we calculate the premium for the yen denominated at-the-money put

for $1:

µ

$ →1

1

0.009

¶

0

=

1

0.009

($0.009 →1 1)

0

=

1

0.009

×$0.0006 = $ 0.0 666 7

= 1 0.0 666 7 ×

1

0.009

= 1 7. 407 8

So the yen denominated at-the-money put for $1 is worth $ 0.0 666 7 or 1

7. 407 8.

I recommend that you use my solution approach, which is less prone to errors

than using complex notations and formulas in the textbook.

Problem 9.8.

The textbook Equations 9.13 and 9.14 are violated.

This is how to arbitrage on the calls. We have two otherwise identical

calls, one with $50 strike price and the other $55. The $50 strike call is more

valuable than the $55 strike call, but the former is selling less than the latter.

To arbitrage, buy low and sell high.

We use T to represent the common exercise date. This deﬁnition works

whether the two options are American or European. If the two options are

American, we’ll ﬁnd arbitrage opportunities if two American options are ex-

ercised simultaneously. If the two options are European, T is the common

expiration date.

The payoﬀ is:

T T T

Transaction t = 0 o

T

< 50 50 ≤ o

T

< 55 o

T

≥ 55

Buy 50 strike call −9 0 o

T

−50 o

T

−50

Sell 55 strike call 10 0 0 −(o

T

−55)

Total 1 0 o

T

−50 ≥ 0 5

At t = 0, we receive $1 free money.

At T, we get non negative cash ﬂows (so we may get some free money, but

we certainly don’t owe anybody anything at T). This is clearly an arbitrage.

www.actuary88.com c °Yufeng Guo 6

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

This is how to arbitrage on the two puts. We have two otherwise identical

puts, one with $50 strike price and the other $55. The $55 strike put is more

valuable than the $50 strike put, but the former is selling less than the latter.

To arbitrage, buy low and sell high.

The payoﬀ is:

T T T

Transaction t = 0 o

T

< 50 50 ≤ o

T

< 55 o

T

≥ 55

Buy 55 strike put −6 55 −o

T

55 −o

T

0

Sell 50 strike put 7 −(50 −o

T

) 0 0

Total 1 5 55 −o

T

0 0

At t = 0, we receive $1 free money.

At T, we get non negative cash ﬂows (so we may get some free money, but

we certainly don’t owe anybody anything at T). This is clearly an arbitrage.

Problem 9.9.

The textbook Equation 9.15 and 9.16 are violated.

We use T to represent the common exercise date. This deﬁnition works

whether the two options are American or European. If the two options are

American, we’ll ﬁnd arbitrage opportunities if two American options are ex-

ercised simultaneously. If the two options are European, T is the common

expiration date.

This is how to arbitrage on the calls. We have two otherwise identical calls,

one with $50 strike price and the other $55. The premium diﬀerence between

these two options should not exceed the strike diﬀerence 15 −10 = 5. In other

words, the 50-strike call should sell no more than 10+5. However, the 50-strike

call is currently selling for 16 in the market. To arbitrage, buy low (the 55-strike

call) and sell high (the 50-strike call).

The $50 strike call is more valuable than the $55 strike call, but the former

is selling less than the latter.

The payoﬀ is:

T T T

Transaction t = 0 o

T

< 50 50 ≤ o

T

< 55 o

T

≥ 55

Buy 55 strike call −10 0 0 o

T

−55

Sell 50 strike call 16 0 −(o

T

−50) −(o

T

−50)

Total 6 0 −(o

T

−50) ≥ −5 −5

So we receive $6 at t = 0. Then at T, our maximum liability is $5. So make

at least $1 free money.

This is how to arbitrage on the puts. We have two otherwise identical calls,

one with $50 strike price and the other $55. The premium diﬀerence between

these two options should not exceed the strike diﬀerence 15 −10 = 5. In other

www.actuary88.com c °Yufeng Guo 7

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

words, the 55-strike put should sell no more than 7 + 5 = 12. However, the

55-strike put is currently selling for 14 in the market. To arbitrage, buy low

(the 50-strike put) and sell high (the 55-strike put).

The payoﬀ is:

T T T

Transaction t = 0 o

T

< 50 50 ≤ o

T

< 55 o

T

≥ 55

Buy 50 strike put −14 50 −o

T

0 0

Sell 55 strike put 7 −(55 −o

T

) −(55 −o

T

) 0

Total 7 −5 −(55 −o

T

) < −5 0

So we receive $7 at t = 0. Then at T, our maximum liability is $5. So make

at least $2 free money.

Problem 9.10.

Suppose there are 3 options otherwise identical but with diﬀerent strike price

1

1

< 1

2

< 1

3

where 1

2

= `1

1

+ (1 −`) 1

2

and 0 < ` < 1.

Then the price of the middle strike price 1

2

must not exceed the price of a

diversiﬁed portfolio consisting of ` units of 1

1

-strike option and (1 −`) units

of 1

2

-strike option:

C [`1

1

+ (1 −`) 1

3

] ≤ `C (1

1

) + (1 −`) C (1

3

)

1 [`1

1

+ (1 −`) 1

3

] ≤ `1 (1

1

) + (1 −`) 1 (1

3

)

The above conditions are called the convexity of the option price with respect

to the strike price. They are equivalent to the textbook Equation 9.17 and 9.18.

If the above conditions are violated, arbitrage opportunities exist.

We are given the following 3 calls:

Strike 1

1

= 50 1

2

= 55 1

3

= 60

Call premium 18 14 9.50

`50 + (1 −`) 60 = 55

→` = 0.5 0.5 (50) + 0.5 (60) = 55

Let’s check:

C [0.5 (50) + 0.5 (60)] = C (55) = 14

0.5C (50) + 0.5C (60) = 0.5 (18) + 0.5 (9.50) = 13. 75

C [0.5 (50) + 0.5 (60)] 0.5C (50) + 0.5C (60)

So arbitrage opportunities exist. To arbitrage, we buy low and sell high.

The cheap asset is the diversiﬁed portfolio consisting of ` units of 1

1

-strike

option and (1 −`) units of 1

3

-strike option. In this problem, the diversiﬁed

portfolio consists of half a 50-strike call and half a 60-strike call.

The expensive asset is the 55-strike call.

www.actuary88.com c °Yufeng Guo 8

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Since we can’t buy half a call option, we’ll buy 2 units of the portfolio (i.e.

buy one 50-strike call and one 60-strike call). Simultaneously,we sell two 55-

strike call options.

We use T to represent the common exercise date. This deﬁnition works

whether the options are American or European. If the options are American,

we’ll ﬁnd arbitrage opportunities if the American options are exercised simulta-

neously. If the options are European, T is the common expiration date.

The payoﬀ is:

T T T T

Transaction t = 0 o

T

< 50 50 ≤ o

T

< 55 55 ≤ o

T

< 60 o

T

≥ 60

buy two portfolios

buy a 50-strike call −18 0 o

T

−50 o

T

−50 o

T

−50

buy a 60-strike call −9.5 0 0 0 o

T

−60

Portfolio total −27. 5 0 o

T

−50 o

T

−50 2o

T

−110

Sell two 55-strike calls 2 (14) = 28 0 0 −2 (o

T

−55) −2 (o

T

−55)

Total 0.5 0 o

T

−50 ≥ 0 60 −o

T

0 0

−27. 5 + 28 = 0.5

o

T

−50 −2 (o

T

−55) = 60 −o

T

2o

T

−110 −2 (o

T

−55) = 0

So we get $0.5 at t = 0, yet we have non negative cash ﬂows at the expiration

date T. This is arbitrage.

The above strategy of buying ` units of 1

1

-strike call, buying (1 −`) units

of 1

3

-strike call, and selling one unit of 1

2

-strike call is called the butterﬂy

spread.

We are given the following 3 puts:

Strike 1

1

= 50 1

2

= 55 1

3

= 60

Put premium 7 10.75 14.45

`50 + (1 −`) 60 = 55

→` = 0.5 0.5 (50) + 0.5 (60) = 55

Let’s check:

1 [0.5 (50) + 0.5 (60)] = 1 (55) = 10.75

0.51 (50) + 0.51 (60) = 0.5 (7) + 0.5 (14.45) = 10. 725

1 [0.5 (50) + 0.5 (60)] .51 (50) + 0.51 (60)

So arbitrage opportunities exist. To arbitrage, we buy low and sell high.

The cheap asset is the diversiﬁed portfolio consisting of ` units of 1

1

-strike

put and (1 −`) units of 1

3

-strike put. In this problem, the diversiﬁed portfolio

consists of half a 50-strike put and half a 60-strike put.

The expensive asset is the 55-strike put.

www.actuary88.com c °Yufeng Guo 9

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Since we can’t buy half a option, we’ll buy 2 units of the portfolio (i.e. buy

one 50-strike put and one 60-strike put). Simultaneously,we sell two 55-strike

put options.

The payoﬀ is:

T T T T

Transaction t = 0 o

T

< 50 50 ≤ o

T

< 55 55 ≤ o

T

< 60 o

T

≥ 60

buy two portfolios

buy a 50-strike put −7 50 −o

T

0 0 0

buy a 60-strike put −14.45 60 −o

T

60 −o

T

60 −o

T

0

Portfolio total −21. 45 110 −2o

T

60 −o

T

60 −o

T

0

Sell two 55-strike puts 2 (10.75) −2 (55 −o

T

) −2 (55 −o

T

) 0 0

Total 0.05 0 o

T

−50 ≥ 0 60 −o

T

0 0

−21. 45 + 2 (10.75) = 0.05

50 −o

T

+ 60 −o

T

= 110 −2o

T

−21. 45 + 2 (10.75) = 0.05

110 −2o

T

−2 (55 −o

T

) = 0

60 −o

T

−2 (55 −o

T

) = o

T

−50

So we get $0.05 at t = 0, yet we have non negative cash ﬂows at the expiration

date T. This is arbitrage.

The above strategy of buying ` units of 1

1

-strike put, buying (1 −`) units

of 1

3

-strike put, and selling one unit of 1

2

-strike put is also called the butterﬂy

spread.

Problem 9.11.

This is similar to Problem 9.10.

We are given the following 3 calls:

Strike 1

1

= 80 1

2

= 100 1

3

= 105

Call premium 22 9 5

80` + 105 (1 −`) = 100

→` = 0.2 0.2 (80) + 0.8 (105) = 100

C [0.2 (80) + 0.8 (105)] = C (100) = 9

0.2C (80) + 0.8C (105) = 0.2 (22) + 0.8 (5) = 8. 4

C [0.2 (80) + 0.8 (105)] 0.2C (80) + 0.8C (105)

So arbitrage opportunities exist. To arbitrage, we buy low and sell high.

The cheap asset is the diversiﬁed portfolio consisting of ` units of 1

1

-strike

option and (1 −`) units of 1

3

-strike option. In this problem, the diversiﬁed

portfolio consists of 0.2 unit of 80-strike call and 0.8 unit of 105-strike call.

The expensive asset is the 100-strike call.

www.actuary88.com c °Yufeng Guo 10

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Since we can’t buy a fraction of a call option, we’ll buy 10 units of the port-

folio (i.e. buy two 80-strike calls and eight 105-strike calls). Simultaneously,we

sell ten 100-strike call options.

We use T to represent the common exercise date. This deﬁnition works

whether the options are American or European. If the options are American,

we’ll ﬁnd arbitrage opportunities if the American options are exercised simulta-

neously. If the options are European, T is the common expiration date.

The payoﬀ is:

T T

Transaction t = 0 o

T

< 80 80 ≤ o

T

< 100

buy ten portfolios

buy two 80-strike calls −2 (22) 0 2 (o

T

−80)

buy eight 105-strike calls −8 (5) 0 0

Portfolio total −84 0 2 (o

T

−80)

Sell ten 100-strike calls 10 (9) 0 0

Total 6 0 2 (o

T

−80) ≥ 0

T T

Transaction t = 0 100 ≤ o

T

< 105 o

T

≥ 105

buy ten portfolios

buy two 80-strike calls −2 (22) 2 (o

T

−80) 2 (o

T

−80)

buy eight 105-strike calls −8 (5) 0 8 (o

T

−105)

Portfolio total −84 2 (o

T

−80) 10o

T

−1000

Sell ten 100-strike calls 10 (9) −10 (o

T

−100) −10 (o

T

−100)

Total 6 8 (105 −o

T

) 0 0

−2 (22) −8 (5) = −44 −40 = −84

−84 + 10 (9) = −84 + 90 = 6

2 (o

T

−80) + 8 (o

T

−105) = 10o

T

−1000

2 (o

T

−80) −10 (o

T

−100) = 840 −8o

T

= 8 (105 −o

T

)

10o

T

−1000 −10 (o

T

−100) = 0

So we receive $6 at t = 0, yet we don’t incur any negative cash ﬂows at

expiration T. So we make at least $6 free money.

We are given the following 3 put:

Strike 1

1

= 80 1

2

= 100 1

3

= 105

Put premium 4 21 24.8

80` + 105 (1 −`) = 100

→` = 0.2 0.2 (80) + 0.8 (105) = 100

1 [0.2 (80) + 0.8 (105)] = 1 (100) = 21

0.21 (80) + 0.81 (105) = 0.2 (4) + 0.8 (24.8) = 20. 64

www.actuary88.com c °Yufeng Guo 11

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

1 [0.2 (80) + 0.8 (105)] 0.21 (80) + 0.81 (105)

So arbitrage opportunities exist. To arbitrage, we buy low and sell high.

The cheap asset is the diversiﬁed portfolio consisting of ` units of 1

1

-strike

option and (1 −`) units of 1

3

-strike option. In this problem, the diversiﬁed

portfolio consists of 0.2 unit of 80-strike put and 0.8 unit of 105-strike put.

The expensive asset is the 100-strike put.

Since we can’t buy half a fraction of an option, we’ll buy 10 units of the port-

folio (i.e. buy two 80-strike puts and eight 105-strike puts). Simultaneously,we

sell ten 100-strike put options.

The payoﬀ is:

T T

Transaction t = 0 o

T

< 80 80 ≤ o

T

< 100

buy ten portfolios

buy two 80-strike puts −2 (4) 2 (80 −o

T

) 0

buy eight 105-strike puts −8 (24.8) 8 (105 −o

T

) 8 (105 −o

T

)

Portfolio total −84 1000 −10o

T

8 (105 −o

T

)

Sell ten 100-strike puts 10 (21) −10 (100 −o

T

) −10 (100 −o

T

)

Total 3. 6 0 2 (o

T

−80) ≥ 0

T T

Transaction t = 0 100 ≤ o

T

< 105 o

T

≥ 105

buy ten portfolios

buy two 80-strike puts −2 (4) 0 0

buy eight 105-strike puts −8 (24.8) 8 (105 −o

T

) 0

Portfolio total −84 8 (105 −o

T

) 0

Sell ten 100-strike puts 10 (21) 0 0

Total 3. 6 8 (105 −o

T

) 0 0

−2 (4) −8 (24.8) = −206. 4

2 (80 −o

T

) + 8 (105 −o

T

) = 1000 −10o

T

−206. 4 + 10 (21) = 3. 6

1000 −10o

T

−10 (100 −o

T

) = 0

8 (105 −o

T

) −10 (100 −o

T

) = 2 (o

T

−80)

We receive $3. 6 at t = 0, but we don’t incur any negative cash ﬂows at T.

So we make at least $3. 6 free money.

Problem 9.12.

For two European options diﬀering only in strike price, the following condi-

tions must be met to avoid arbitrage (see my study guide for explanation):

0 ≤ C

Ju:

(1

1

. T) −C

Ju:

(1

2

. T) ≤ 1\ (1

2

−1

1

) if 1

1

< 1

2

www.actuary88.com c °Yufeng Guo 12

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

0 ≤ 1

Ju:

(1

2

. T) −1

Ju:

(1

1

. T) ≤ 1\ (1

2

−1

1

) if 1

1

< 1

2

a.

Strike 1

1

= 90 1

2

= 95

Call premium 10 4

C (1

1

) −C (1

2

) = 10 −4 = 6

1

2

−1

1

= 95 −90 = 5

C (1

1

) −C (1

2

) 1

2

−1

1

≥ 1\ (1

2

−1

1

)

Arbitrage opportunities exist.

To arbitrage, we buy low and sell high. The cheap call is the 95-strike call;

the expensive call is the 90-strike call.

We use T to represent the common exercise date. This deﬁnition works

whether the two options are American or European. If the two options are

American, we’ll ﬁnd arbitrage opportunities if two American options are ex-

ercised simultaneously. If the two options are European, T is the common

expiration date.

The payoﬀ is:

T T T

Transaction t = 0 o

T

< 90 90 ≤ o

T

< 95 o

T

≥ 95

Buy 95 strike call −4 0 0 o

T

−95

Sell 90 strike call 10 0 −(o

T

−90) −(o

T

−90)

Total 6 0 −(o

T

−90) ≥ −5 −5

We receive $6 at t = 0, yet we our max liability at T is −5. So we’ll make

at least $1 free money.

b.

T = 2 r = 0.1

Strike 1

1

= 90 1

2

= 95

Call premium 10 5.25

C (1

1

) −C (1

2

) = 10 −5.25 = 4. 75

1

2

−1

1

= 95 −90 = 5

1\ (1

2

−1

1

) = 5c

−0.1(2)

= 4. 094

C (1

1

) −C (1

2

) 1\ (1

2

−1

1

)

Arbitrage opportunities exist.

Once again, we buy low and sell high. The cheap call is the 95-strike call;

the expensive call is the 90-strike call.

The payoﬀ is:

T T T

Transaction t = 0 o

T

< 90 90 ≤ o

T

< 95 o

T

≥ 95

Buy 95 strike call −5.25 0 0 o

T

−95

Sell 90 strike call 10 0 −(o

T

−90) −(o

T

−90)

Deposit 4. 75 in savings −4. 75 4. 75c

0.1(2)

4. 75c

0.1(2)

4. 75c

0.1(2)

Total 0 5. 80 95. 80 −o

T

0 0.80

www.actuary88.com c °Yufeng Guo 13

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

4. 75c

0.1(2)

= 5. 80

−(o

T

−90) + 4. 75c

0.1(2)

= 95. 80 −o

T

o

T

−95 −(o

T

−90) + 4. 75c

0.1(2)

= 0.80

Our initial cost is zero. However, our payoﬀ is always non-negative. So we

never lose money. This is clearly an arbitrage.

It’s important that the two calls are European options. If they are American,

they can be exercised at diﬀerent dates. Hence the following non-arbitrage

conditions work only for European options:

0 ≤ C

Ju:

(1

1

. T) −C

Ju:

(1

2

. T) ≤ 1\ (1

2

−1

1

) if 1

1

< 1

2

0 ≤ 1

Ju:

(1

2

. T) −1

Ju:

(1

1

. T) ≤ 1\ (1

2

−1

1

) if 1

1

< 1

2

c.

We are given the following 3 calls:

Strike 1

1

= 90 1

2

= 100 1

3

= 105

Call premium 15 10 6

`90 + (1 −`) 105 = 100 ` =

1

3

→

1

3

(90) +

2

3

(105) = 100

C

∙

1

3

(90) +

2

3

(105)

¸

= C (100) = 10

1

3

C (90) +

2

3

C (105) =

1

3

(15) +

2

3

(6) = 9

C

∙

1

3

(90) +

2

3

(105)

¸

1

3

C (90) +

2

3

C (105)

Hence arbitrage opportunities exist. To arbitrage, we buy low and sell high.

The cheap asset is the diversiﬁed portfolio consisting of

1

3

unit of 90-strike

call and

2

3

unit of 105-strike call.

The expensive asset is the 100-strike call.

Since we can’t buy a partial option, we’ll buy 3 units of the portfolio (i.e.

buy one 90-strike call and two 105-strike calls). Simultaneously,we sell three

100-strike calls.

The payoﬀ at expiration T:

T T T T

Transaction t = 0 o

T

< 90 90 ≤ o

T

< 100 100 ≤ o

T

< 105 o

T

≥ 105

buy 3 portfolios

buy one 90-strike call −15 0 o

T

−90 o

T

−90 o

T

−90

buy two 105-strike calls 2 (−6) 0 0 0 2 (o

T

−105)

Portfolios total −27 0 o

T

−90 o

T

−90 3o

T

−300

Sell three 100-strike calls 3 (10) 0 0 −3 (o

T

−100) −3 (o

T

−100)

Total 3 0 o

T

−90 ≥ 0 2 (105 −o

T

) 0 0

www.actuary88.com c °Yufeng Guo 14

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

−15 + 2 (−6) = −27

o

T

−90 + 2 (o

T

−105) = 3o

T

−300

−27 + 3 (10) = 3

o

T

−90 −3 (o

T

−100) = 210 −2o

T

= 2 (105 −o

T

)

3o

T

−300 −3 (o

T

−100) = 0

So we receive $3 at t = 0, but we incur no negative payoﬀ at T. So we’ll

make at least $3 free money.

Problem 9.13.

a. If the stock pays dividend, then early exercise of an American call option

may be optimal.

Suppose the stock pays dividend at t

1

.

Time 0 ... ... t

1

... ... T

Pro and con for exercising the call early at t

1

.

• +. If you exercise the call immediately before t

1

, you’ll receive dividend

and earn interest during [t

1

. T]

• −. You’ll pay the strike price 1 at t

1

, losing interest you could have

earned during [t

1

. T]. If the interest rate, however, is zero, you won’t lose

any interest.

• −. You throw away the remaining call option during [t

1

. T]. Had you

waited, you would have the call option during [t

1

. T]

If the accumulated value of the dividend exceeds the value of the remaining

call option, then it’s optimal to exercise the stock at t

1

.

As explained in my study guide, it’s never optimal to exercise an American

put early if the interest rate is zero.

Problem 9.14.

a. The only reason that early exercise might be optimal is that the underlying

asset pays a dividend. If the underlying asset doesn’t pay dividend, then it’s

never optimal to exercise an American call early. Since Apple doesn’t pay

dividend, it’s never optimal to exercise early.

b. The only reason to exercise an American put early is to earn interest on

the strike price. The strike price in this example is one share of AOL stock.

Since AOL stocks won’t pay any dividends, there’s no beneﬁt for owning an

AOL stock early. Thus it’s never optimal to exercise the put.

If the Apple stock price goes to zero and will always stay zero, then there’s

no beneﬁt for delaying exercising the put; there’s no beneﬁt for exercising the

www.actuary88.com c °Yufeng Guo 15

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

put early either (since AOL stocks won’t pay dividend). Exercising the put

early and exercising the put at maturity have the same value.

If, however, the Apple stock price goes to zero now but may go up in the

future, then it’s never optimal to exercise the put early. If you don’t exercise

early, you leave the door open that in the future the Apple stock price may

exceed the AOL stock price, in which case you just let your put expire worthless.

If the Apple stock price won’t exceed the AOL stock price, you can always

exercise the put and exchange one Apple stock for one AOL stock. There’s no

hurry to exercise the put early.

c. If Apple is expected to pay dividend, then it might be optimal to exercise

the American call early and exchange one AOL stock for one Apple stock.

However, as long as the AOL stock won’t pay any dividend, it’s never optimal

to exercise the American put early to exchange one Apple stock for one AOL

stock.

Problem 9.15.

This is an example where the strike price grows over time.

If the strike price grows over time, the longer-lived option is at least as

valuable as the shorter lived option. Refer to Derivatives Markets Page 298.

We have two European calls:

Call #1 1

1

= 100c

0.05(1.5)

= 107. 788 T

1

= 1.5 C

1

= 11.50

Call #2 1

2

= 100c

0.05

= 105. 127 T

2

= 1 C

2

= 11.924

The longer-lived call is cheaper than the shorter-lived call, leading to arbi-

trage opportunities. To arbitrage, we buy low (Call #1) and sell high (Call

#2).

The payoﬀ at expiration T

1

= 1.5 if o

T

2

< 100c

0.05

= 105. 127

T

1

T

1

Transaction t = 0 T

2

o

T

1

< 100c

0.05(1.5)

o

T

1

≥ 100c

0.05(1.5)

Sell Call #2 11.924 0 0 0

buy Call #1 −11.50 0 o

T1

−100c

0.05(1.5)

Total 0.424 0 o

T1

−100c

0.05(1.5)

≥ 0

We receive $0.424 at t = 0, yet our payoﬀ at T

1

is always non-negative. This

is clearly an arbitrage.

The payoﬀ at expiration T

1

= 1.5 if o

T

2

≥ 100c

0.05

= 105. 127

T

1

T

1

Transaction t = 0 T

2

o

T

1

< 100c

0.05(1.5)

o

T

1

≥ 100c

0.05(1.5)

Sell Call #2 11.924 100c

0.05

−o

T2

100c

0.05(1.5)

−o

T1

100c

0.05(1.5)

−o

T1

buy Call #1 −11.50 0 o

T1

−100c

0.05(1.5)

Total 0.424 100c

0.05(1.5)

−o

T

1

< 0 0

www.actuary88.com c °Yufeng Guo 16

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

If o

T

2

≥ 100c

0.05

, then payoﬀ of the sold Call #2 at T

2

is 100c

0.05

− o

T

2

.

From T

2

to T

1

,

• 100c

0.05

grows into

¡

100c

0.05

¢

c

0.05(T

1

−T

2

)

=

¡

100c

0.05

¢

c

0.05(0.5)

= 100c

0.05(1.5)

• o

T2

becomes o

T1

(i.e. the stock price changes from o

T2

to o

T1

)

We receive $0.424 at t = 0, yet our payoﬀ at T

1

can be negative. This is not

an arbitrage.

So as long as o

T2

< 100c

0.05

= 105. 127 , there’ll be arbitrage opportunities.

Problem 9.16.

Suppose we do the following at t = 0:

1. Pay C

o

to buy a call

2. Lend 1\ (1) = 1c

−:

at r

J

3. Sell a put, receiving 1

b

4. Short sell one stock, receiving o

b

0

The net cost is 1

b

+o

b

0

−(C

o

+1c

−:

).

The payoﬀ at T is:

If o

T

< 1 If o

T

≥ 1

Transactions t = 0

Buy a call −C

o

0 o

T

−1

Lend 1c

−:

at r

J

−1c

:

1 1

Sell a put 1

b

o

T

−1 0

Short sell one stock o

b

0

−o

T

−o

T

Total 1

b

+o

b

0

−(C

o

+1c

−:

) 0 0

The payoﬀ is always zero. To avoid arbitrage, we need to have

1

b

+o

b

0

−(C

o

+1c

−:

) ≤ 0

Similarly, we can do the following at t = 0:

1. Sell a call, receiving C

b

2. Borrow 1\ (1) = 1c

−:

at r

1

3. Buy a put, paying 1

o

4. Buy one stock, paying o

o

0

www.actuary88.com c °Yufeng Guo 17

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

The net cost is

¡

C

b

+1c

−:

¢

−

¡

1

b

+o

b

0

¢

.

The payoﬀ at T is:

If o

T

< 1 If o

T

≥ 1

Transactions t = 0

Sell a call C

b

0 1 −o

T

Borrow 1c

−:

at r

1

1c

−:

−1 −1

Buy a put −1

o

1− o

T

0

Buy one stock −o

o

0

o

T

o

T

Total

¡

C

b

+1c

−:

¢

−

¡

1

b

+o

b

0

¢

0 0

The payoﬀ is always zero. To avoid arbitrage, we need to have

¡

C

b

+1c

−:

¢

−

¡

1

b

+o

b

0

¢

≤ 0

Problem 9.17.

a. According to the put-call parity, the payoﬀ of the following position is

always zero:

1. Buy the call

2. Sell the put

3. Short the stock

4. Lend the present value of the strike price plus dividend

The existence of the bid-ask spread and the borrowing-lending rate diﬀerence

doesn’t change the zero payoﬀ of the above position. The above position always

has a zero payoﬀ whether there’s a bid-ask spread or a diﬀerence between the

borrowing rate and the lending rate.

If there is no transaction cost such as a bid-ask spread, the initial gain of

the above position is zero. However, if there is a bid-ask spread, then to avoid

arbitrage, the initial gain of the above position should be zero or negative.

The initial gain of the position is:

¡

1

b

+o

b

0

¢

−[C

o

+1\

:

(1) +1\

:

(1i·)]

There’s no arbitrage if

¡

1

b

+o

b

0

¢

−[C

o

+1\

:

(1) +1\

:

(1i·)] ≤ 0

In this problem, we are given

• r

J

= 0.019

• r

1

= 0.02

• o

b

0

= 84.85. We are told to ignore the transaction cost. In addition, we

are given that the current stock price is 84.85. So o

b

0

= 84.85.

• The dividend is 0.18 on November 8, 2004.

www.actuary88.com c °Yufeng Guo 18

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

To ﬁnd the expiration date, you need to know this detail. Puts and calls

are called equity options at the Chicago Board of Exchange (CBOE). In CBOE,

the expiration date of an equity option is the Saturday immediately following

the third Friday of the expiration month. (To verify this, go to www.cboe.com.

Click on "Products" and read "Production Speciﬁcations.")

If the expiration month is November, 2004, the third Friday is November 19.

Then the expiration date is November 20.

T =

11´20´2004 −10´15´2004

365

=

36

365

= 0.09863

If the expiration month is January, 2005, the third Friday is January 21.

Then the expiration date is January 22, 2005.

T =

1´22´2005 −10´15´2004

365

Calculate the days between 1/22/2005 and10/15/2004 isn’t easy. Fortu-

nately,we can use a calculator. BA II Plus and BA II Plus Professional have

"Date" Worksheet. When using Date Worksheet, use the ACT mode. ACT

mode calculates the actual days between two dates. If you use the 360 day

mode, you are assuming that there are 360 days between two dates.

When using the date worksheet, set DT1 (i.e. Date 1) as October 10, 2004

by entering 10.1504; set DT2 (i.e. Date 2) as January 22, 2004 by entering

1.2204. The calculator should tell you that DBD=99 (i.e. the days between two

days is 99 days).

So T =

1´22´2005 −10´15´2004

365

=

99

365

= 0.271 23

If you have trouble using the date worksheet, refer to the guidebook of BA

II Plus or BA II Plus Professional.

The dividend day is t

1

=

11´8´2004 −10´15´2004

365

=

24

365

= 0.06 575

1\

:

(1i·) = 0.18c

−0.06575(0.019)

= 0.18

1\

:

(1) = 1c

−0.019T

¡

1

b

+o

b

0

¢

−[C

o

+1\

:

(1) +1\

:

(1i·)]

= 1

b

+ 84.85 −

¡

C

o

+1c

−0.019T

+ 0.18

¢

1 T C

o

1

b

¡

1

b

+o

b

0

¢

−[C

o

+1\

:

(1) +1\

:

(1i·)]

75 0.0986 10.3 0.2 0.2 + 84.85 −

¡

10.3 + 75c

−0.019×0.0986

+ 0.18

¢

= −0.29

80 0.0986 5.6 0.6 0.6 + 84.85 −

¡

5.6 + 80c

−0.019×0.0986

+ 0.18

¢

= −0.18

85 0.0986 2.1 2.1 2.1 + 84.85 −

¡

2.1 + 85c

−0.019×0.0986

+ 0.18

¢

= −0.17

90 0.0986 0.35 5.5 5.5 + 84.85 −

¡

0.35 + 90c

−0.019×0.0986

+ 0.18

¢

= −1. 15

75 0.271 2 10.9 0.7 0.7 + 84.85 −

¡

10.9 + 75c

−0.019×0.271 2

+ 0.18

¢

= −0.14

80 0.271 2 6.7 1.45 1.45 + 84.85 −

¡

6.7 + 80c

−0.019×0.271 2

+ 0.18

¢

= −0.17

85 0.271 2 3.4 3.1 3.1 + 84.85 −

¡

3.4 + 85c

−0.019×0.271 2

+ 0.18

¢

= −0.19

90 0.271 2 1.35 6.1 6.1 + 84.85 −

¡

1.35 + 90c

−0.019×0.271 2

+ 0.18

¢

= −0.12

b. According to the put-call parity, the payoﬀ of the following position is

always zero:

www.actuary88.com c °Yufeng Guo 19

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

1. Sell the call

2. Borrow the present value of the strike price plus dividend

3. Buy the put

4. Buy one stock

If there is transaction cost such as the bid-ask spread, then to avoid arbitrage,

the initial gain of the above position is zero. However, if there is a bid-ask spread,

the initial gain of the above position can be zero or negative.

The initial gain of the position is:

C

b

+1\

:

(1) +1\

:

(1i·) −(1

o

+o

o

0

)

There’s no arbitrage if

C

b

+1\

:

(1) +1\

:

(1i·) −(1

o

+o

o

0

) ≤ 0

1\

:

(1i·) = 0.18c

−0.06575(0.02)

= 0.18

1\

:

(1) = 1c

−0.02T

C

b

+1\

:

(1)+1\

:

(1i·)−(1

o

+o

o

0

) = C

b

+1c

−0.02T

+0.18−(1

o

+ 84.85)

1 T C

b

1

o

C

b

+1\

:

(1) +1\

:

(1i·) −(1

o

+o

o

0

)

75 0.0986 9.9 0.25 9.9 + 75c

−0.02×0.0986

+ 0.18 −(0.25 + 84.85) = −0.17

80 0.0986 5.3 0.7 5.3 + 80c

−0.02×0.0986

+ 0.18 −(0.7 + 84.85) = −0.23

85 0.0986 1.9 2.3 1.9 + 85c

−0.02×0.0986

+ 0.18 −(2.3 + 84.85) = −0.24

90 0.0986 0.35 5.8 0.35 + 90c

−0.02×0.0986

+ 0.18 −(5.8 + 84.85) = −0.30

75 0.271 2 10.5 0.8 10.5 + 75c

−0.02×0.271 2

+ 0.18 −(0.8 + 84.85) = −0.38

80 0.271 2 6.5 1.6 6.5 + 80c

−0.02×0.271 2

+ 0.18 −(1.6 + 84.85) = −0.20

85 0.271 2 3.2 3.3 3.2 + 85c

−0.02×0.271 2

+ 0.18 −(3.3 + 84.85) = −0.23

90 0.271 2 1.2 6.3 1.2 + 90c

−0.02×0.271 2

+ 0.18 −(6.3 + 84.85) = −0.26

Problem 9.18.

Suppose there are 3 options otherwise identical but with diﬀerent strike price

1

1

< 1

2

< 1

3

where 1

2

= `1

1

+ (1 −`) 1

2

and 0 < ` < 1.

Then the price of the middle strike price 1

2

must not exceed the price of a

diversiﬁed portfolio consisting of ` units of 1

1

-strike option and (1 −`) units

of 1

2

-strike option:

C [`1

1

+ (1 −`) 1

3

] ≤ `C (1

1

) + (1 −`) C (1

3

)

1 [`1

1

+ (1 −`) 1

3

] ≤ `1 (1

1

) + (1 −`) 1 (1

3

)

The above conditions are called the convexity of the option price with respect

to the strike price. They are equivalent to the textbook Equation 9.17 and 9.18.

If the above conditions are violated, arbitrage opportunities exist.

1 T C

b

C

o

80 0.271 2 6.5 6.7

85 0.271 2 3.2 3.4

90 0.271 2 1.2 1.35

www.actuary88.com c °Yufeng Guo 20

CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

85 = `(80) + (1 −`) (90) →` = 0.5

a.

If we buy a 80-strike call, buy a 90-strike call, sell two 85-strike calls

• A 80-strike call and a 90-strike call form a diversiﬁed portfolio of calls,

which is always as good as two 85-strike calls

• So the cost of buying a 80-strike call and a 90-strike call can never be less

than the revenue of selling two 85-strike calls

What we pay if we buy a 80-strike call and a 90-strike call: 6.7 + 1.35 = 8.

05

What we get if we sell two 85-strike calls: 3.2 ×2 = 6. 4

8. 05 6. 4

So the convexity condition is met.

I recommend that you don’t bother memorizing textbook Equation 9.17 and

9.18.

b. If we sell a 80-strike call, sell a 90-strike call, buy two 85-strike calls

• A 80-strike call and a 90-strike call form a diversiﬁed portfolio of calls,

which is always as good as two 85-strike calls

• So the revenue of selling a 80-strike call and a 90-strike call should never

be less than the cost of buying two 85-strike calls.

What we get if we sell a 80-strike call and a 90-strike call: 6.5 + 1.2 = 7. 7

What we pay if we buy two 85-strike calls: 3.4 ×2 = 6. 8

7. 7 6.8

So the convexity condition is met.

c. To avoid arbitrage, the following two conditions must be met:

C [`1

1

+ (1 −`) 1

3

] ≤ `C (1

1

) + (1 −`) C (1

3

)

1 [`1

1

+ (1 −`) 1

3

] ≤ `1 (1

1

) + (1 −`) 1 (1

3

)

These conditions must be met no matter you are a market-maker or anyone

else buying or selling options, no matter you pay a bid-ask spread or not.

www.actuary88.com c °Yufeng Guo 21

Contents

Introduction 9 Parity and other option relationships 10 Binomial option pricing I 11 Binomial option pricing II 12 Black-Scholes formula 13 Market making and delta hedging 14 Exotic options: I 18 Lognormal distribution 19 Monte Carlo simulation 20 Brownian motion and Ito’s lemma 21 The Black-Scholes equation 22 Exotic options: II 23 Volatility 24 Interest rate models vii 1 23 91 107 125 149 161 177 187 193 203 205 209

iii

Please report any errors to yufeng.Preface This is Guo’s solution to Derivatives Markets (2nd edition ISBN 0-321-28030-X) for SOA MFE or CAS Exam 3 FE. This book is the exclusive property of Yufeng Guo.guo.com. v . Redistribution of this book in any form is prohibited. Unlike the oﬃcial solution manual published by Addison-Wesley. Problems that are out of the scope of the SOA Exam MFE and CAS Exam 3 FE syllabus are excluded. this solution manual provides solutions to both the evennumbered and odd-numbered problems for the chapters that are on the SOA Exam MFE and CAS Exam 3 FE syllabus.actuary@gmail.

Make sure you download the textbook errata from http://www.html vii .kellogg.edu/faculty/mcdonald/htm/typos2e_01. northwestern. Obviously.Introduction Recommendations on using this solution manual: 1. you’ll need to buy Derivatives Markets (2nd edition) to see the problems. 2.

0 = 800 = 005 =0 =1 = 815 = 75 = 45 a.1. Buy stock+ sell call+buy put=buy () + () = + 0 → ( = 815) = 0 + − + |{z} = 800 + (−75) + 45 = 770 |{z} |{z} buy stock sell call buy put So the position is equivalent to depositing 770 in a savings account (or buying a bond with present value equal to 770) and receiving 815 one year later.2. 0 = 32 = 227 = 612 = 05 = 35 = 004 = 006 + () = + 0 − 227 + 35−004(05) = + 32−006(05) Problem 9. = 5 522 7 0 = 32 = 612 = 05 = 30 = 429 = 264 = 004 + () = + 0 − () 429 + 30−004(05) = 264 + 32 − () () = 0944 Problem 9.Chapter 9 Parity and other option relationships Problem 9. 770 = 815 = 0056 8 1 .3.

To arbitrage. we need to have: ( = 815) = 0 + |{z} + |{z} = 815−005 = 775 25 − |{z} buy stock sell call buy put → − = 0 − () = 800 − 775 25 = 24 75 d. So 0 = $095.CHAPTER 9. 1).05%. To avoid arbitrage. The underlying asset is 1. selling a call. Hence = 004 Since is expressed in dollars. we receive 770 = 815. our risk free proﬁt at time one is 00568 − 005 = 000717 3. One year later. To solve this type of problems. our risk free proﬁt at time one is 000717 3×770 = 5 52. and 0 should all be expressed in dollars. As a result. Alternative answer: we can burrow at 5% (continuously compounding) and lend at 56 8% (continuously compounding). PARITY AND OTHER OPTION RELATIONSHIPS So we earn 568%. If we borrow dollars at time zero. we’ll earn 000717 3 dollars at time one. = $00571 = $093 is the internal growth rate of the underlying asset (i. 0 is the current (dollar price) of the underlying. b. However. and buying a put is the same as depositing () in the savings account. () needs to be calculated using the dollar risk free interest = 006. we "borrow low and earn high. . we should just earn the risk free interest rate = 005.com c °Yufeng Guo 2 . We want to ﬁnd the dollar cost of a put option on this underlying.68%. we actually earn = 0056 8 . earning a risk free 0. If we do such transactions." We borrow 770 from a bank at 0. Notice that the net cost of buying a stock.4. if we borrow $770 at time zero. We pay the bank 770005 = 809 48. So if we borrow $1 at time zero. . just use the standard put-call parity. selling a call.e. and buying a put. To avoid calculation errors. we’ll earn 5 52 proﬁt. and buying a put is 770. 00571 + 093−006(1) = + 095−004(1) = $002 02 www. c. − = 0 − () = 800 − − = 800 − −005 If = 780 − = 800 − 780−005 = 58 041 If = 800 − = 800 − 800−005 = 39 016 If = 820 − = 800 − 820−005 = 19 992 If = 840 − = 800 − 840−005 = 0967 Problem 9. Our proﬁt is 815 − 809 48 = 5 52 per transaction. selling a call. The typical put-call parity: + () = + 0 − . clearly identify the underlying asset.actuary88. Buying a stock. We use the borrowed 770 to ﬁnance buying a stock.

CHAPTER 9. As I explained in my study guide. don’t bother memorizing the following complex formula: µ ¶ 1 1 $ (0 ) = 0 0 Just use my approach to solve this type of problems. PARITY AND OTHER OPTION RELATIONSHIPS Problem 9.actuary88. we have: 95 µ ¶ 1 1 1 ( 8763) = (8763) =9 224 2 × 10−4 100 100 95 µ ¶ 1 → → 1 =9 224 2 × 10−4 100 0 So the price of a euro-denominated call on 1 yen with strike price = is 9 224 2 × 10−4 1 100 www.com c °Yufeng Guo 3 . 95 =1 or 1 = 95 Yen-denominated put on 1 euro with strike price Y100 has a premium Y8763 → (1 → 100)0 =Y8763 What’s the strike price of a euro-denominated call on 1 yen? → 1 Calculate the price of a euro-denominated call on 1 yen with strike price ( → 1 )0 = ? 1 → 100 1 →1 100 1 The strike price of the corresponding euro-denominated yen call is = =001 100 ¶ µ 1 1 1 →1 = × (1 → 100)0 = ( 8763) 100 100 100 0 → Since 1 = 1 .5. Convert information to symbols: 1 The exchange rate is 95 yen per euro.

deposit − in a savings account.com c °Yufeng Guo 4 . we buy a call. and sell − unit of Yen.6. The standard put-call parity is: + () = + 0 − . The underlying asset is one yen.7. There are two puts out there. + − = + 0 − 00006 + 0009−005(1) = + 0009−001(1) 00006 + 0008561 = + 0008 91 = $000025 b.actuary88. the forward price is: 0 = 0 − = 0920 04−0035(05) 005(05) = $0926 97 Problem 9. We’ll solve Part b ﬁrst. is the internal growth rate of the underlying asset (i. . 1). 00404 + 09−005(05) = 00141 + 0 −0035(05) 0 = $0920 04 So the current price of the underlying (i. a.e. =0 00004 −00006 −0009−005(1) 0009−001(1) $000015 =1 0009 − 0009 0 0009 0 =1 ≥ 0009 0 − 0009 0009 0 Sell expensive put Buy call Deposit − in savings Short sell − unit of Yen Total 00004 − 00006 − 0009−005(1) + 0009−001(1) = $000015 www. the currency exchange rate is $0920 04 =1 a.e. One is the synthetically created put using the formula: = + − − 0 − The other is the put in the market selling for the price for $00004. The underlying asset is 1. 1) is 0 = $0920 04. PARITY AND OTHER OPTION RELATIONSHIPS Problem 9. b.7. build a put a low cost and sell it at a high price. and 0 should all be expressed in dollars. we: • Sell the expensive put for $00004 • Build a cheap put for $000025. To build a put. To arbitrage. According to the textbook Equation 5. At = 0. . 0 is the current (dollar price) of the underlying. In other words.CHAPTER 9.

notice that under the call option. "Give yen and get $1" is represented by ( → $1). First. "Give $0009 and get 1" is represented by ($0009 → 1). we get −001(1) yen. This option’s premium at time zero is ( → $1)0 .009 at = 1 to time zero. Here the call holder can give yen and get $1. So the at-the0009 1 money yen denominated call on $1 is = .0006. the call holder can give $0009 and get 1. So we have: $00006+$0009−005 = ( 1 → $0009)0 + $0009−001(1) ( 1 → $0009)0 ¶ $2 506 16 × 10−4 = µ 1 1 2 506 16 × 10−4 = 1 → $1 ( 1 → $0009)0 = $ = $2 0009 0009 0009 0 −2 2 784 62 × 10 = 3 094 784 62 × 10−2 = 0009 www. This option’s premium at time zero is $0. Hence we have: ($0009 → 1)0 = $00006 We are asked to ﬁnd the yen denominated at the money call for $1.com c °Yufeng Guo 5 .actuary88. To translate this into symbols. we use the dollar interest rate 5%. PARITY AND OTHER OPTION RELATIONSHIPS At = 0. the strike price is equal to the current exchange rate). we receive $000015 yet we don’t incur any liabilities at = 1 (so we receive $000015 free money at = 0). Dollar-denominated at-the-money yen call sells for $0. we have $1 = . Since at time zero $0009 = 1. Our task is to ﬁnd this option’s 0009 ¶ µ 1 → $1 =? premium: 0009 0 We’ll ﬁnd the premium for 1 →$0009. we need to calculate . ( 1) = $0009−001(1) If we discount Y1 from = 1 to time zero." 0009 We’ll use the general put-call parity: ( → )0 + ( ) = ( → )0 + ( ) ($0009 → 1)0 + ($0009) = ( 1 → $0009)0 + ( 1) ($0009) = $0009−005(1) Since we are discounting $0. c. which is equal to $0009−001(1) .CHAPTER 9." Once we ﬁnd this premium. At-the-money means = 0 (i.0006. we’ll scale it and ﬁnd the premium of "give 1 yen and get $1. the option of "give 1 yen and get $0009.e. the strike price of the yen denominated dollar 1 call.

which is less prone to errors than using complex notations and formulas in the textbook. We are also asked to identify the relationship between the yen denominated at the money call for $1 and the dollar-denominated yen put.com c °Yufeng Guo 6 .14 are violated. The textbook Equations 9. one with $50 strike price and the other $55.CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS So the yen denominated at the money call for $1 is worth $2 784 62 × 10−2 or 3 094. To arbitrage. This is how to arbitrage on the calls. we receive $1 free money. we get non negative cash ﬂows (so we may get some free money. If the two options are European. www.actuary88. Problem 9.8. If the two options are American. The payoﬀ is: Transaction Buy 50 strike call Sell 55 strike call Total =0 −9 10 1 50 0 0 0 50 ≤ 55 − 50 0 − 50 ≥ 0 ≥ 55 − 50 − ( − 55) 5 0 At = 0. buy low and sell high. At . The relationship is that we use the premium of the latter option to calculate the premium of the former option. This deﬁnition works whether the two options are American or European. Next. We have two otherwise identical calls. but we certainly don’t owe anybody anything at ). We use to represent the common exercise date. This is clearly an arbitrage.13 and 9. is the common expiration date. we’ll ﬁnd arbitrage opportunities if two American options are exercised simultaneously. but the former is selling less than the latter. The $50 strike call is more valuable than the $55 strike call. I recommend that you use my solution approach. we calculate the premium for the yen denominated at-the-money put for $1: µ $→ 1 0009 ¶ = 1 ($0009 → 1)0 0009 1 = × $00006 = $ 00 666 7 0009 1 = 7 407 8 = 00 666 7 × 0009 So the yen denominated at-the-money put for $1 is worth $ 00 666 7 or 7 407 8.

is selling less than the latter. we get non negative cash ﬂows (so we may get some free money.16 are violated. In other www. We have two otherwise identical calls.com c °Yufeng Guo 7 . but the former is selling less than the latter. This is clearly an arbitrage.9. buy low (the 55-strike call) and sell high (the 50-strike call). Then at . We use to represent the common exercise date.15 and 9. The textbook Equation 9. To arbitrage. However. is the common expiration date.CHAPTER 9. the 50-strike call should sell no more than 10 + 5. PARITY AND OTHER OPTION RELATIONSHIPS This is how to arbitrage on the two puts. At . we receive $1 free money. our maximum liability is $5. one with $50 strike price and the other $55. one with $50 strike price and the other $55. but we certainly don’t owe anybody anything at ). If the two options are American. The premium diﬀerence between these two options should not exceed the strike diﬀerence 15 − 10 = 5. In other words. the 50-strike call is currently selling for 16 in the market. We have two otherwise identical puts. The payoﬀ is: Transaction = 0 50 50 ≤ 55 ≥ 55 Buy 55 strike put −6 55 − 55 − 0 Sell 50 strike put 7 − (50 − ) 0 0 Total 1 5 55 − 0 0 At = 0. buy low and sell high. The premium diﬀerence between these two options should not exceed the strike diﬀerence 15 − 10 = 5.actuary88. This is how to arbitrage on the puts. one with $50 strike price and the other $55. So make at least $1 free money. we’ll ﬁnd arbitrage opportunities if two American options are exercised simultaneously. The payoﬀ is: Transaction = 0 50 50 ≤ 55 Buy 55 strike call −10 0 0 Sell 50 strike call 16 0 − ( − 50) Total 6 0 − ( − 50) ≥ −5 but the former ≥ 55 − 55 − ( − 50) −5 So we receive $6 at = 0. We have two otherwise identical calls. If the two options are European. This is how to arbitrage on the calls. This deﬁnition works whether the two options are American or European. The $55 strike put is more valuable than the $50 strike put. Problem 9. The $50 strike call is more valuable than the $55 strike call. To arbitrage.

com c °Yufeng Guo 8 3 = 60 950 . arbitrage opportunities exist. the 55-strike put should sell no more than 7 + 5 = 12. Then at . the diversiﬁed portfolio consists of half a 50-strike call and half a 60-strike call. We are given the following 3 calls: Strike 1 = 50 2 = 55 Call premium 18 14 50 + (1 − ) 60 = 55 → = 05 05 (50) + 05 (60) = 55 Let’s check: [05 (50) + 05 (60)] = (55) = 14 05 (50) + 05 (60) = 05 (18) + 05 (950) = 13 75 [05 (50) + 05 (60)] 05 (50) + 05 (60) So arbitrage opportunities exist.actuary88. In this problem.18. If the above conditions are violated. The payoﬀ is: Transaction = 0 50 50 ≤ 55 ≥ 55 Buy 50 strike put −14 50 − 0 0 Sell 55 strike put 7 − (55 − ) − (55 − ) 0 Total 7 −5 − (55 − ) −5 0 So we receive $7 at = 0. www. buy low (the 50-strike put) and sell high (the 55-strike put). PARITY AND OTHER OPTION RELATIONSHIPS words. So make at least $2 free money. They are equivalent to the textbook Equation 9. the 55-strike put is currently selling for 14 in the market.10. The expensive asset is the 55-strike call. Problem 9. The cheap asset is the diversiﬁed portfolio consisting of units of 1 -strike option and (1 − ) units of 3 -strike option. Then the price of the middle strike price 2 must not exceed the price of a diversiﬁed portfolio consisting of units of 1 -strike option and (1 − ) units of 2 -strike option: [1 + (1 − ) 3 ] ≤ (1 ) + (1 − ) (3 ) [1 + (1 − ) 3 ] ≤ (1 ) + (1 − ) (3 ) The above conditions are called the convexity of the option price with respect to the strike price.CHAPTER 9. our maximum liability is $5. Suppose there are 3 options otherwise identical but with diﬀerent strike price 1 2 3 where 2 = 1 + (1 − ) 2 and 0 1. To arbitrage.17 and 9. we buy low and sell high. However. To arbitrage.

The expensive asset is the 55-strike put. we buy low and sell high. we’ll buy 2 units of the portfolio (i.actuary88. yet we have non negative cash ﬂows at the expiration date . we’ll ﬁnd arbitrage opportunities if the American options are exercised simultaneously. The payoﬀ is: 50 0 0 0 0 0 50 ≤ 55 − 50 0 − 50 0 − 50 ≥ 0 55 ≤ 60 − 50 0 − 50 −2 ( − 55) 60 − 0 ≥ 60 − 50 − 60 2 − 110 −2 ( − 55) 0 Transaction buy two portfolios buy a 50-strike call buy a 60-strike call Portfolio total Sell two 55-strike calls Total =0 −18 −95 −27 5 2 (14) = 28 05 −27 5 + 28 = 05 − 50 − 2 ( − 55) = 60 − 2 − 110 − 2 ( − 55) = 0 So we get $05 at = 0. The above strategy of buying units of 1 -strike call.we sell two 55strike call options. The cheap asset is the diversiﬁed portfolio consisting of units of 1 -strike put and (1 − ) units of 3 -strike put. the diversiﬁed portfolio consists of half a 50-strike put and half a 60-strike put. To arbitrage. This deﬁnition works whether the options are American or European.e.com c °Yufeng Guo 9 3 = 60 1445 . buying (1 − ) units of 3 -strike call. We are given the following 3 puts: Strike 1 = 50 2 = 55 Put premium 7 1075 50 + (1 − ) 60 = 55 → = 05 05 (50) + 05 (60) = 55 Let’s check: [05 (50) + 05 (60)] = (55) = 1075 05 (50) + 05 (60) = 05 (7) + 05 (1445) = 10 725 [05 (50) + 05 (60)] 5 (50) + 05 (60) So arbitrage opportunities exist. buy one 50-strike call and one 60-strike call).CHAPTER 9. www. PARITY AND OTHER OPTION RELATIONSHIPS Since we can’t buy half a call option. If the options are American. In this problem. If the options are European. and selling one unit of 2 -strike call is called the butterﬂy spread. is the common expiration date. We use to represent the common exercise date. Simultaneously. This is arbitrage.

8 unit of 105-strike call.2 unit of 80-strike call and 0. This is arbitrage. The cheap asset is the diversiﬁed portfolio consisting of units of 1 -strike option and (1 − ) units of 3 -strike option. buy one 50-strike put and one 60-strike put). the diversiﬁed portfolio consists of 0.we sell two 55-strike put options. buying (1 − ) units of 3 -strike put. This is similar to Problem 9. Simultaneously.e. Problem 9.11. We are given the following 3 calls: Strike 1 = 80 2 = 100 Call premium 22 9 80 + 105 (1 − ) = 100 → = 02 02 (80) + 08 (105) = 100 [02 (80) + 08 (105)] = (100) = 9 02 (80) + 08 (105) = 02 (22) + 08 (5) = 8 4 [02 (80) + 08 (105)] 02 (80) + 08 (105) So arbitrage opportunities exist. The payoﬀ is: 50 50 − 60 − 110 − 2 −2 (55 − ) 0 50 ≤ 55 0 60 − 60 − −2 (55 − ) − 50 ≥ 0 55 ≤ 60 0 60 − 60 − 0 60 − 0 ≥ 60 0 0 0 0 0 Transaction buy two portfolios buy a 50-strike put buy a 60-strike put Portfolio total =0 −7 −1445 −21 45 Sell two 55-strike puts 2 (1075) Total 005 −21 45 + 2 (1075) = 005 50 − + 60 − = 110 − 2 −21 45 + 2 (1075) = 005 110 − 2 − 2 (55 − ) = 0 60 − − 2 (55 − ) = − 50 So we get $005 at = 0. and selling one unit of 2 -strike put is also called the butterﬂy spread.com c °Yufeng Guo 10 3 = 105 5 .10. yet we have non negative cash ﬂows at the expiration date . PARITY AND OTHER OPTION RELATIONSHIPS Since we can’t buy half a option. The above strategy of buying units of 1 -strike put.CHAPTER 9. To arbitrage. The expensive asset is the 100-strike call. www.actuary88. we buy low and sell high. In this problem. we’ll buy 2 units of the portfolio (i.

If the options are European. We are given the following 3 put: Strike 1 = 80 2 = 100 Put premium 4 21 80 + 105 (1 − ) = 100 → = 02 02 (80) + 08 (105) = 100 [02 (80) + 08 (105)] = (100) = 21 02 (80) + 08 (105) = 02 (4) + 08 (248) = 20 64 www. Simultaneously. we’ll ﬁnd arbitrage opportunities if the American options are exercised simultaneously. is the common expiration date.actuary88. We use to represent the common exercise date. we’ll buy 10 units of the portfolio (i. The payoﬀ is: 80 0 0 0 0 0 80 ≤ 100 2 ( − 80) 0 2 ( − 80) 0 2 ( − 80) ≥ 0 ≥ 105 2 ( − 80) 8 ( − 105) 10 − 1000 −10 ( − 100) 0 Transaction buy ten portfolios buy two 80-strike calls buy eight 105-strike calls Portfolio total Sell ten 100-strike calls Total =0 −2 (22) −8 (5) −84 10 (9) 6 Transaction buy ten portfolios buy two 80-strike calls buy eight 105-strike calls Portfolio total =0 −2 (22) −8 (5) −84 100 ≤ 105 2 ( − 80) 0 2 ( − 80) −10 ( − 100) 8 (105 − ) 0 Sell ten 100-strike calls 10 (9) Total 6 −2 (22) − 8 (5) = −44 − 40 = −84 −84 + 10 (9) = −84 + 90 = 6 2 ( − 80) + 8 ( − 105) = 10 − 1000 2 ( − 80) − 10 ( − 100) = 840 − 8 = 8 (105 − ) 10 − 1000 − 10 ( − 100) = 0 So we receive $6 at = 0. This deﬁnition works whether the options are American or European. So we make at least $6 free money. If the options are American.com c °Yufeng Guo 11 3 = 105 248 .we sell ten 100-strike call options.CHAPTER 9. buy two 80-strike calls and eight 105-strike calls). yet we don’t incur any negative cash ﬂows at expiration . PARITY AND OTHER OPTION RELATIONSHIPS Since we can’t buy a fraction of a call option.e.

Problem 9.actuary88.2 unit of 80-strike put and 0. The cheap asset is the diversiﬁed portfolio consisting of units of 1 -strike option and (1 − ) units of 3 -strike option. For two European options diﬀering only in strike price. In this problem. buy two 80-strike puts and eight 105-strike puts). Simultaneously.CHAPTER 9. So we make at least $3 6 free money.com c °Yufeng Guo 12 . PARITY AND OTHER OPTION RELATIONSHIPS [02 (80) + 08 (105)] 02 (80) + 08 (105) So arbitrage opportunities exist. Since we can’t buy half a fraction of an option. but we don’t incur any negative cash ﬂows at . To arbitrage. The expensive asset is the 100-strike put.we sell ten 100-strike put options.e.8 unit of 105-strike put. The payoﬀ is: 80 2 (80 − ) 8 (105 − ) 1000 − 10 −10 (100 − ) 0 100 ≤ 105 0 8 (105 − ) 8 (105 − ) 0 8 (105 − ) 0 80 ≤ 100 0 8 (105 − ) 8 (105 − ) −10 (100 − ) 2 ( − 80) ≥ 0 ≥ 105 0 0 0 0 0 Transaction buy ten portfolios buy two 80-strike puts buy eight 105-strike puts Portfolio total Sell ten 100-strike puts Total =0 −2 (4) −8 (248) −84 10 (21) 3 6 Transaction buy ten portfolios buy two 80-strike puts buy eight 105-strike puts Portfolio total Sell ten 100-strike puts Total =0 −2 (4) −8 (248) −84 10 (21) 3 6 −2 (4) − 8 (248) = −206 4 2 (80 − ) + 8 (105 − ) = 1000 − 10 −206 4 + 10 (21) = 3 6 1000 − 10 − 10 (100 − ) = 0 8 (105 − ) − 10 (100 − ) = 2 ( − 80) We receive $3 6 at = 0. we’ll buy 10 units of the portfolio (i. the diversiﬁed portfolio consists of 0.12. we buy low and sell high. the following conditions must be met to avoid arbitrage (see my study guide for explanation): 0 ≤ (1 ) − (2 ) ≤ (2 − 1 ) if 1 2 www.

If the two options are American.com c °Yufeng Guo 13 . yet we our max liability at is −5. the expensive call is the 90-strike call.CHAPTER 9. Strike Call premium 1 = 90 10 2 = 95 4 (1 ) − (2 ) = 10 − 4 = 6 2 − 1 = 95 − 90 = 5 (1 ) − (2 ) 2 − 1 ≥ (2 − 1 ) Arbitrage opportunities exist. is the common expiration date. The cheap call is the 95-strike call. The cheap call is the 95-strike call. So we’ll make at least $1 free money.actuary88. We use to represent the common exercise date. The payoﬀ is: Transaction =0 90 90 ≤ 95 ≥ 95 Buy 95 strike call −525 0 0 − 95 Sell 90 strike call 10 0 − ( − 90) − ( − 90) 01(2) 01(2) Deposit 4 75 in savings −4 75 4 75 4 75 4 7501(2) Total 0 5 80 95 80 − 0 080 www. PARITY AND OTHER OPTION RELATIONSHIPS 0 ≤ (2 ) − (1 ) ≤ (2 − 1 ) if 1 2 a. the expensive call is the 90-strike call. b. we buy low and sell high. =2 = 01 Strike 1 = 90 Call premium 10 2 = 95 525 (1 ) − (2 ) = 10 − 525 = 4 75 2 − 1 = 95 − 90 = 5 (2 − 1 ) = 5−01(2) = 4 094 (1 ) − (2 ) (2 − 1 ) Arbitrage opportunities exist. If the two options are European. The payoﬀ is: Transaction = 0 90 90 ≤ 95 ≥ 95 Buy 95 strike call −4 0 0 − 95 Sell 90 strike call 10 0 − ( − 90) − ( − 90) Total 6 0 − ( − 90) ≥ −5 −5 We receive $6 at = 0. we buy low and sell high. To arbitrage. we’ll ﬁnd arbitrage opportunities if two American options are exercised simultaneously. Once again. This deﬁnition works whether the two options are American or European.

com =0 −15 2 (−6) −27 3 (10) 3 90 0 0 0 0 0 90 ≤ 100 − 90 0 − 90 0 − 90 ≥ 0 100 ≤ 105 − 90 0 − 90 −3 ( − 100) 2 (105 − ) 0 14 ≥ 105 − 90 2 ( − 105) 3 − 300 −3 ( − 100) 0 3 = 105 6 c °Yufeng Guo .CHAPTER 9. 3 The expensive asset is the 100-strike call. So we never lose money. we’ll buy 3 units of the portfolio (i. However. If they are American. our payoﬀ is always non-negative. It’s important that the two calls are European options. Simultaneously. We are given the following 3 calls: Strike 1 = 90 2 = 100 Call premium 15 10 1 90 + (1 − ) 105 = 100 = 3 1 2 → (90) + (105) = 100 3 ¸ ∙3 2 1 (90) + (105) = (100) = 10 3 3 2 1 2 1 (90) + (105) = (15) + (6) = 9 3∙ 3 3 ¸ 3 2 1 2 1 (90) + (105) (90) + (105) 3 3 3 3 Hence arbitrage opportunities exist. To arbitrage. The payoﬀ at expiration : Transaction buy 3 portfolios buy one 90-strike call buy two 105-strike calls Portfolios total Sell three 100-strike calls Total www. Since we can’t buy a partial option. 1 The cheap asset is the diversiﬁed portfolio consisting of unit of 90-strike 3 2 call and unit of 105-strike call.we sell three 100-strike calls.e. they can be exercised at diﬀerent dates. Hence the following non-arbitrage conditions work only for European options: 0 ≤ (1 ) − (2 ) ≤ (2 − 1 ) if 1 2 0 ≤ (2 ) − (1 ) ≤ (2 − 1 ) if 1 2 c. we buy low and sell high. buy one 90-strike call and two 105-strike calls). PARITY AND OTHER OPTION RELATIONSHIPS 4 7501(2) = 5 80 − ( − 90) + 4 7501(2) = 95 80 − − 95 − ( − 90) + 4 7501(2) = 080 Our initial cost is zero.actuary88. This is clearly an arbitrage.

however. then it’s optimal to exercise the stock at As explained in my study guide.. The strike price in this example is one share of AOL stock.. it’s never optimal to exercise an American put early if the interest rate is zero. . Had you waited.... Problem 9. Thus it’s never optimal to exercise the put. Since AOL stocks won’t pay any dividends.. Problem 9. If you exercise the call immediately before . there’s no beneﬁt for owning an AOL stock early. a. there’s no beneﬁt for exercising the www. . you would have the call option during [ ] If the accumulated value of the dividend exceeds the value of the remaining call option.CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS −15 + 2 (−6) = −27 − 90 + 2 ( − 105) = 3 − 300 −27 + 3 (10) = 3 − 90 − 3 ( − 100) = 210 − 2 = 2 (105 − ) 3 − 300 − 3 ( − 100) = 0 So we receive $3 at = 0. b. you’ll receive dividend and earn interest during [ ] • −. Suppose the stock pays dividend at . then there’s no beneﬁt for delaying exercising the put. but we incur no negative payoﬀ at . If the underlying asset doesn’t pay dividend.14. If the Apple stock price goes to zero and will always stay zero. You’ll pay the strike price at .13. If the stock pays dividend.actuary88. If the interest rate. it’s never optimal to exercise early. The only reason that early exercise might be optimal is that the underlying asset pays a dividend. you won’t lose any interest. • −.. The only reason to exercise an American put early is to earn interest on the strike price.. You throw away the remaining call option during [ ]. losing interest you could have earned during [ ]. Since Apple doesn’t pay dividend. a. So we’ll make at least $3 free money.com c °Yufeng Guo 15 . then early exercise of an American call option may be optimal. then it’s never optimal to exercise an American call early. • +. Pro and con for exercising the call early at . . is zero. Time 0 .

Problem 9. however. PARITY AND OTHER OPTION RELATIONSHIPS put early either (since AOL stocks won’t pay dividend). Exercising the put early and exercising the put at maturity have the same value. If Apple is expected to pay dividend. This is clearly an arbitrage. it’s never optimal to exercise the American put early to exchange one Apple stock for one AOL stock. There’s no hurry to exercise the put early. 1 = 1150 2 = 11924 The longer-lived call is cheaper than the shorter-lived call. If you don’t exercise early. the Apple stock price goes to zero now but may go up in the future. we buy low (Call #1) and sell high (Call #2). the longer-lived valuable as the shorter lived option. However. If.com =0 11924 −1150 0424 2 100005 − 2 1 1 100005(15) 100005(15) − 1 0 100005(15) − 1 0 1 1 ≥ 100005(15) 100005(15) − 1 1 − 100005(15) 0 16 c °Yufeng Guo . then it might be optimal to exercise the American call early and exchange one AOL stock for one Apple stock. then it’s never optimal to exercise the put early. you can always exercise the put and exchange one Apple stock for one AOL stock. The payoﬀ at expiration 1 = 15 if 2 100005 = 105 127 Transaction Sell Call #2 buy Call #1 Total =0 11924 −1150 0424 2 0 1 1 100005(15) 0 0 0 1 1 ≥ 100005(15) 0 1 − 100005(15) 1 − 100005(15) ≥ 0 We receive $0424 at = 0. c. If the Apple stock price won’t exceed the AOL stock price. The payoﬀ at expiration 1 = 15 if 2 ≥ 100005 = 105 127 Transaction Sell Call #2 buy Call #1 Total www.actuary88. as long as the AOL stock won’t pay any dividend. you leave the door open that in the future the Apple stock price may exceed the AOL stock price. leading to arbitrage opportunities. To arbitrage. Refer to Derivatives We have two European calls: Call #1 1 = 100005(15) = 107 788 1 = 15 Call #2 2 = 100005 = 105 127 2 = 1 option is at least as Markets Page 298. This is an example where the strike price grows over time.15. yet our payoﬀ at 1 is always non-negative.CHAPTER 9. If the strike price grows over time. in which case you just let your put expire worthless.

yet our payoﬀ at 1 can be negative. the stock price changes from 2 to 1 ) We receive $0424 at = 0. paying 0 www. Pay to buy a call 2. Buy one stock. receiving 0 The net cost is + 0 − ( + − ).actuary88. Buy a put. we need to have + 0 − ( + − ) ≤ 0 Similarly. The payoﬀ at is: If Transactions Buy a call Lend − at Sell a put Short sell one stock Total =0 − − 0 + 0 − ( + − ) 0 − − 0 If ≥ − 0 − 0 The payoﬀ is always zero. Lend () = − at 3.CHAPTER 9.16. Sell a put. there’ll be arbitrage opportunities. Suppose we do the following at = 0: 1. Borrow () = − at 3.e. Short sell one stock. then payoﬀ of the sold Call #2 at 2 is 100005 − 2 . PARITY AND OTHER OPTION RELATIONSHIPS If 2 ≥ 100005 . paying 4. ¡ ¡ ¢ ¢ • 100005 grows into 100005 005(1 −2 ) = 100005 005(05) = 100005(15) • 2 becomes 1 (i. Problem 9. So as long as 2 100005 = 105 127 . This is not an arbitrage. To avoid arbitrage.com c °Yufeng Guo 17 . we can do the following at = 0: 1. receiving 2. From 2 to 1 . Sell a call. receiving 4.

Buy the call 2. Sell the put 3. PARITY AND OTHER OPTION RELATIONSHIPS ¡ ¢ ¡ ¢ The net cost is + − − + 0 .actuary88. we are given that the current stock price is 84. The payoﬀ at is: Transactions Sell a call Borrow − at Buy a put Buy one stock Total =0 − − −0 ¡ ¢ ¡ ¢ + − − + 0 If 0 − − 0 If ≥ − − 0 0 The payoﬀ is ¢ ¡ zero. So 0 = 8485.CHAPTER 9. Short the stock 4.com c °Yufeng Guo 18 . www. the initial gain of the above position is zero. 2004. According to the put-call parity. we are given • = 0019 • = 002 • 0 = 8485.85. the payoﬀ of the following position is always zero: 1.17. we need to have always To ¡ + − − + 0 ≤ 0 Problem 9. We are told to ignore the transaction cost. then to avoid arbitrage. The initial gain of the position is: ¡ ¢ + 0 − [ + () + ()] There’s no arbitrage if ¡ ¢ + 0 − [ + () + ()] ≤ 0 In this problem. If there is no transaction cost such as a bid-ask spread. • The dividend is 018 on November 8. However. The above position always has a zero payoﬀ whether there’s a bid-ask spread or a diﬀerence between the borrowing rate and the lending rate. if there is a bid-ask spread. In addition. ¢ avoid arbitrage. a. Lend the present value of the strike price plus dividend The existence of the bid-ask spread and the borrowing-lending rate diﬀerence doesn’t change the zero payoﬀ of the above position. the initial gain of the above position should be zero or negative.

the payoﬀ of the following position is always zero: www. you are assuming that there are 360 days between two dates. set DT2 (i. 2005. In CBOE. 2005. Puts and calls are called equity options at the Chicago Board of Exchange (CBOE). 1222005 − 10152004 99 So = = = 0271 23 365 365 If you have trouble using the date worksheet. According to the put-call parity. Date 1) as October 10.e. The calculator should tell you that DBD=99 (i.") If the expiration month is November.com c °Yufeng Guo 19 . refer to the guidebook of BA II Plus or BA II Plus Professional.e.CHAPTER 9.2204. set DT1 (i. Date 2) as January 22. the third Friday is November 19. Fortunately. If you use the 360 day mode. Click on "Products" and read "Production Speciﬁcations. use the ACT mode. Then the expiration date is January 22. the days between two days is 99 days).e.com.cboe.actuary88.we can use a calculator. When using Date Worksheet. the third Friday is January 21. PARITY AND OTHER OPTION RELATIONSHIPS To ﬁnd the expiration date. When using the date worksheet. 2004 by entering 1. you need to know this detail. 2004 by entering 10. 1182004 − 10152004 24 = = 006 575 The dividend day is = 365 365 () = 018−006575(0019) = 018 () = −0019 ¡ ¢ + 0 − [ ¡+ () + ()] ¢ = + 8485 − + −0019 + 018 ¡ ¢ + 0 − [ + () + ()] ¢ ¡ 75 00986 103 02 02 + 8485 − ¡103 + 75−0019×00986 + 018 = −029 ¢ 80 00986 56 06 06 + 8485 − ¡56 + 80−0019×00986 + 018¢ = −018 85 00986 21 21 21 + 8485 − ¡21 + 85−0019×00986 + 018 ¢ −017 = 90 00986 035 55 55 + 8485 − ¡035 + 90−0019×00986 + 018 ¢ = −1 15 75 0271 2 109 07 07 + 8485 − 109 + 75−0019×0271 2 + 018¢ = −014 ¡ 80 0271 2 67 145 145 + 8485 − 67 + 80−0019×0271 2 + 018 = −017 ¡ ¢ 85 0271 2 34 31 31 + 8485 − ¡34 + 85−0019×0271 2 + 018 ¢ −019 = 90 0271 2 135 61 61 + 8485 − 135 + 90−0019×0271 2 + 018 = −012 b. (To verify this. 1222005 − 10152004 = 365 Calculate the days between 1/22/2005 and10/15/2004 isn’t easy. 2004. BA II Plus and BA II Plus Professional have "Date" Worksheet. 11202004 − 10152004 36 = = = 009863 365 365 If the expiration month is January. go to www. Then the expiration date is November 20. ACT mode calculates the actual days between two dates.1504. the expiration date of an equity option is the Saturday immediately following the third Friday of the expiration month.

PARITY AND OTHER OPTION RELATIONSHIPS 1. The initial gain of the position is: + () + () − ( + 0 ) There’s no arbitrage if + () + () − ( + 0 ) ≤ 0 −006575(002) () = 018 = 018 () = −002 + ()+ ()−( + 0 ) = +−002 +018−( + 8485) 75 80 85 90 75 80 85 90 00986 00986 00986 00986 0271 2 0271 2 0271 2 0271 2 99 53 19 035 105 65 32 12 025 07 23 58 08 16 33 63 + () + () − ( + 0 ) −002×00986 99 + 75 + 018 − (025 + 8485) = −017 53 + 80−002×00986 + 018 − (07 + 8485) = −023 19 + 85−002×00986 + 018 − (23 + 8485) = −024 035 + 90−002×00986 + 018 − (58 + 8485) = −030 105 + 75−002×0271 2 + 018 − (08 + 8485) = −038 65 + 80−002×0271 2 + 018 − (16 + 8485) = −020 32 + 85−002×0271 2 + 018 − (33 + 8485) = −023 12 + 90−002×0271 2 + 018 − (63 + 8485) = −026 Problem 9.18.actuary88.com . the initial gain of the above position can be zero or negative. They are equivalent to the textbook Equation 9. Buy the put 4. Buy one stock If there is transaction cost such as the bid-ask spread. the initial gain of the above position is zero. if there is a bid-ask spread.17 and 9. If the above conditions are violated. Then the price of the middle strike price 2 must not exceed the price of a diversiﬁed portfolio consisting of units of 1 -strike option and (1 − ) units of 2 -strike option: [1 + (1 − ) 3 ] ≤ (1 ) + (1 − ) (3 ) [1 + (1 − ) 3 ] ≤ (1 ) + (1 − ) (3 ) The above conditions are called the convexity of the option price with respect to the strike price. arbitrage opportunities exist. Suppose there are 3 options otherwise identical but with diﬀerent strike price 1 2 3 where 2 = 1 + (1 − ) 2 and 0 1.18. then to avoid arbitrage. Borrow the present value of the strike price plus dividend 3. However. Sell the call 2. 80 85 90 0271 2 0271 2 0271 2 65 32 12 67 34 135 c °Yufeng Guo 20 www.CHAPTER 9.

sell two 85-strike calls • A 80-strike call and a 90-strike call form a diversiﬁed portfolio of calls. which is always as good as two 85-strike calls • So the cost of buying a 80-strike call and a 90-strike call can never be less than the revenue of selling two 85-strike calls What we pay if we buy a 80-strike call and a 90-strike call: 67 + 135 = 8 05 What we get if we sell two 85-strike calls: 32 × 2 = 6 4 8 05 6 4 So the convexity condition is met. no matter you pay a bid-ask spread or not. PARITY AND OTHER OPTION RELATIONSHIPS 85 = (80) + (1 − ) (90) → = 05 a. I recommend that you don’t bother memorizing textbook Equation 9. If we sell a 80-strike call. To avoid arbitrage. If we buy a 80-strike call.17 and 9. c. b. www. What we get if we sell a 80-strike call and a 90-strike call: 65 + 12 = 7 7 What we pay if we buy two 85-strike calls: 34 × 2 = 6 8 7 7 68 So the convexity condition is met.com c °Yufeng Guo 21 . sell a 90-strike call.CHAPTER 9. buy two 85-strike calls • A 80-strike call and a 90-strike call form a diversiﬁed portfolio of calls.18. the following two conditions must be met: [1 + (1 − ) 3 ] ≤ (1 ) + (1 − ) (3 ) [1 + (1 − ) 3 ] ≤ (1 ) + (1 − ) (3 ) These conditions must be met no matter you are a market-maker or anyone else buying or selling options.actuary88. buy a 90-strike call. which is always as good as two 85-strike calls • So the revenue of selling a 80-strike call and a 90-strike call should never be less than the cost of buying two 85-strike calls.

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