CHAPTER 10

Properties of Stock Options

Practice Questions

Problem 10.9.
What is a lower bound for the price of a six-month call option on a non-dividend-paying
stock when the stock price is $80, the strike price is $75, and the risk-free interest rate is
10% per annum?

The lower bound is

Problem 10.10
What is a lower bound for the price of a two-month European put option on a non-dividend-
paying stock when the stock price is $58, the strike price is $65, and the risk-free interest
rate is 5% per annum?

The lower bound is

Problem 10.11. (Modified)

A four-month European call option on a non-dividend-paying stock is currently selling for
$6.20. The stock price is $64, the strike price is $60. The risk-free interest rate is 12% per
annum for all maturities. What opportunities are there for an arbitrageur?
What is your answer to this question if the premium was $6.40?

There are following steps that has to be followed at these kind of questions.

 First step is to check the lower bound of the call. The reason is simply to check if
there is arbitrage possibilities or not. If the call price is lower than the calculated
lower bound this will lead to arbitrage possibilities if not no arbitrage possibilities
exist.

The lower bound for call is:

−rT
c ≥ S 0−Ke
so ;
4
−0.12 ×
12
c ≥64−60 e
c ≥6.35
Call option price must be greater than $6.35 but actually, our call price is $6.20 so
arbitrage potential exists

 Due to arbitrage potential exists second step is to buy the option and short sell the
stock.
−6.20+64=57.8
  At day one, we have $57.8 at hand. Due to concept of time value of the money we
have to invest this amount by the risk-free interest rate for 4-months
4
0.12×
12
57.8 e =60.16
At the end of the maturity we have, $60.16 at hand, the next step is to choose either to
exercise the option or not.

 We have to scenarios in this case either stock price at the maturity is greater than the
strike price or less than the strike price
o If ST ≥ K we will exercise the option
o If ST < K we will not exericise the option and buy from the market.

If first scenario occurs, we will exercise the option, which means we will buy the stock at a
price of $60 due to our position at the option. We will use our proceeds which we obtained
before and pay $60 out of it.
60.16−60=0.16
So we will land with $0.16 of profit by exercising the option when ST ≥ K .

The second scenario is when ST < K . When this case occurs, it will not be wise the exercise the
option. At the market, stock is much cheaper than our agreed price. This will lead us to
acquire the option from the market.
Our profit increases by every dollar decrease in the stock price. The maximum amount of
profit (theoretically) that we can land is 60.16 when stock price decreases to 0
60.16−0=6 0.16
In both cases, we have to return the share to original owner of the share. This means we
cannot keep to share for capital gain potential that might happen in the future.

The second part of the question asks if there is any arbitrage possibilities if the call price is
$6.40. This case will bring no arbitrage possibilities because; call price is greater than the
lower bound of the call.

6.40>6.35

Problem 10.12.
A one-month European put option on a non-dividend-paying stock is currently selling for
$2.50. The stock price is $47, the strike price is $50, and the risk-free interest rate is 6% per
annum. What opportunities are there for an arbitrageur?

In this case the present value of the strike price is . Because

the condition in equation (10.5) is violated. An arbitrageur should borrow $49.50 at 6% for
one month, buy the stock, and buy the put option. This generates a profit in all circumstances.
If the stock price is above $50 in one month, the option expires worthless, but the stock can
be sold for at least $50. A sum of $50 received in one month has a present value of $49.75
today. The strategy therefore generates profit with a present value of at least $0.25.
If the stock price is below $50 in one month the put option is exercised and the stock owned
is sold for exactly $50 (or $49.75 in present value terms). The trading strategy therefore
generates a profit of exactly $0.25 in present value terms.
Problem 10.14 (Modified)
The price of a European call that expires in six months and has a strike price of $30 is $2.
The underlying stock price is $29.The term structure is flat, with all risk-free interest rates
being 10%. What is the price of a European put option that expires in six months and has a
strike price of $30?

We can use put call parity formula in order to find the value of the put. The put-call parity
formula tells us that if one call and one put has same strike price maturity and underlying
stock is same we can work out missing values in the formula.
−rt
c + K e = p+ S 0

−0.10 ×0.5
2+30 e = p+29

p=¿1.54

So the price of the put should be $1.54

Another Problem

The price of a European call that expires in six months and has a strike price of $30 is $2.
The underlying stock price is $29.The term structure is flat, with all risk-free interest rates
being 10%. Price of a European put option that expires in six months is $1.75 and has a
strike price of $30.
Are there any arbitrage possibilities available? If so how?

If there is arbitrage possibilities we can check it with using put-call parity formula.
−rt
c + K e = p+ S 0
−0.10 ×0.5
2+30 e =1.75+29
30.54 ≠ 30.75
So the left side is smaller than the right side this means that we have to buy the call and short
the put.

 Step 1, buy the call, short the put and short-sale the stock

This will lead to a profit of

−2+1.75+29=28.75

 Invest the proceeds until the maturity

28.75 e 0.10 ×0.5 =30.22

 This third part is the critical part of these kind of questions. Do not forget we are
 holding two positions one is long call and other one short put. Both of them means
that we will buy the stock if it exercised.

Two scenarios still exists;

o If ST ≥ K we will exercise the option
o If ST < K counterparty will exercise the option

So both cases we buy the stock at a price equals to the strike price. We will use the proceeds
we obtained to acquire share.

Therefore, for the both scenarios our profit is $0.22.

30.22−30=¿0.22