Tutorial 7

Note:

Profi Profi
t/ Lo t/
Lo
Loss ng Loss
ng
X= CaS Pre 0 X= S
Pre 0 Pu
5. ll 6.
miu 0 50 miu 1 t
50
m . m . S=
S=
8
Premium 4
Premium 6.0
6.0
0
= (6.00-5.50) + 0
= (6.50-6.00) 0 +
0
X=
0.30 = RM0.30 Exercise X=
0.90 = RM1.40 Exercise
Price Price
S=When
(call option) Price S= Price
of intrinsic value is positive.
S>X, of
(in-the-money)
Underlying Underlying
(put option) When X>S, intrinsic value is positive. (in-the-money)
Asset Asset
X=S, intrinsic value = 0 (at-the-money)

Intrinsic value = negative = 0 (out-of-the-money)

Premium….

1. You bought an at-the-money, 3-month call option on Syarikat GEDC two

months ago. GEDC’s stock price has been unchanged since then. State the
impact on the call’s premium. Would it be higher or lower than the premium
you paid? Explain why.

Answer: The premium will become lower, since less time to maturity, so
lower time value. When time value decreases, premium decreases.
 Profit/
Loss

now
Premi
um 2
(now) X month
0 s agoS
Premi
um
(2
month When X=S,
s ago) intrinsic value
X=Strike Price =0
S = underlying asset price

a. Suppose you had bought an at-the-money (S=E) put option instead,

would its premium now be higher or lower? Explain.

Answer: The premium will also become lower since time value is
lesser. When time value drops, premium drops.

Profit/
Loss

Premiu
m X Price of
(now) 0
Premiu underlyi
m ng
(2 asset
2 now
month
s ago) months
X = Strike Price ago

b. If you had bought the put option in (a) above, and GEDC had paid a
dividend yesterday, would the premium be higher or lower today?
Explain why.

Answer:
 After a stock goes ex-dividend, the share price typically drops by the
amount of dividend paid to reflect the fact that new shareholders are
not entitled to that dividend payment.

Before this, the put option is at the money (as mentioned in (a)), which
means the spot price equal to strike price. However, when the dividend
was paid, the stock price dropped. By exercising the put option, we can
still sell the underlying asset on a strike price that is greater than the
spot price. Hence, in this case, it will turn to be in-the-money as the
strike price is greater than the spot price. Hence, it is said that there is
intrinsic value. Put will be worth more since the stock price will be
dropped ex-dividend, thereby increasing the intrinsic value.

(Call

Intrinsic Value is the differences between strike price and spot price.

Profit/
Loss

Intrinsic X Price of
Value 0 underlyi
Lo ng
ng asset
Premi
Put
When spot price is um =
decrease, the Intrinsic IV +
value increase. TV

2. A call option with one month to maturity is selling at RM0.25

premium. The exercise price is RM6.00. The underlying stock is selling at
RM5.85.
 a. Calculate the IV, TV and the premium.

Answer:

premium = intrinsic value + time value

RM0.25 = (RM6.00-5.85) + time value

Time value = RM0.25- RM0.15 =RM0.10 (Wrong answer!)

First, you need to identify whether there is an intrinsic value. In this case, the
call option has intrinsic value only if the strike price is smaller than the spot
price (in-the-money). However, in this case, the spot price (RM5.85) is smaller
than the strike price. Hence, there is no intrinsic value.

Premium = Intrinsic Value + Time Value

RM0.25 = 0 + RM0.25

Time Value = RM0.25

Premium = RM0.25

Intrinsic Value = RM0

Profit/
Loss Long
Call
X =
Price of
0 RM6.00
Premiu Underlyi
m ng
Asset
S=
When stirke price >
RM5.85
spot price, then
intrinsic value =0.
X= Exercise Price
S= Price of
a. Underlying
Suppose Asset
the maturity period for the above option is lengthened but
everything else is unchanged.

(i) State the impact on IV and TV.

Answer: IV has no change but TV is higher.

(ii) Show the impact by mean of a graph.

 Answer: There should be a near downward shift in the call value
curve.

Profit/
Loss Long
Call

X Price of
0
Premiu Underlyi
0.2 ng Asset
m
5

X= Exercise Price
S= Price of Underlying
Asset

3. XYZ Corp. current stock price = RM6.00.

30-day call 30-day put

5.50 call = 0.80 5.50 put = 0.40

 6.00 call = 0.40 6.00 put = 0.50

6.50 call = 0.30 6.50 put = 0.90

The highlighted numbers are TIME VALUE.

1. Which options are in-the-money (go-profit)? By what amount?

For call, Spot price > Strike price = in-the-money

5.5 call is in-the-money by 0.50 (6-5.50).

For put, Strike price > Spot price = in-the-money

6.5 put is in the money by 0.50 (6.50-5.50)

Profi Profi
t/ Lo t/
Lo
Loss ng Loss
ng
X= CaS X= S
Pre 0 Pre 0 Pu
5. ll 6.
miu 0 50 miu 1 t
50
m .
S= m . S=
8
Premium 4
Premium 6.0
6.0
0
=intrinsic value 0 0
= intrinsic value
0
X=
+ time valueExercise X=
+ time value Exercise
Price +
= (6.00-5.50) Price +
= (6.50-6.00)
S= Price of
0.30 = RM0.80 S= Price of
0.90 = RM1.40
Underlying Underlying
Asset Asset

1. Which options are at-the-money?

Answer: 6.00 put and 6.00 call

 Profi Profi
t/ Lo t/
Lo
Loss ng Loss
ngX=
X= Ca S S
Pre 0 Pre 0 Pu6.
6. ll
miu 0 00 miu 0 t 50
m . . S=
S= m
4
Premium 5
Premium 6.0
6.0
0
= (6.00-6.00) + 0
= (6.00-6.00)0 +
0
X= Exercise
0.40 = RM0.40 X= Exercise
0.50 = RM0.50
Price Price
1. Would the S= Price of
premium of a 60-day option be S= Price
higher of than the premium
or lower
above if it were (i) a call option?, (ii) a put option?
Underlying Underlying
Asset Asset
Answer: The premiums would be higher for both options since longer time to
maturity, so higher time value, and thus, increasing the premium. However,
this has no effect on intrinsic value.

4. State the difference in the margining process for buyers and sellers in the
futures markets as opposed to options. State the reason for this difference.

Answer: In futures both long and short positions have to post margin. In
option, only the short position is margined since the long can only lose a
maximum equal to premium paid.
5. Your company has just exported Crude Palm Oil to a Japanese customer.
You will receive 30 million Yen in 90 days. Do you have exposure? Suppose
forwards, futures and options were available on the currency, which would be
the best instrument to hedge? Explain why.

Answer: Yes, there is an exposure to currency risk of Yen which can cause
losses. Hence, it is advised to use futures since cheapest and most liquid
relatively. (Foward will have high agency risk. Option will be expensive as you
need to pay premium despite you can choose to exercise or not.)
6. State and briefly explain 2 factors that increase the likelihood that an
American will be exercised early.

American option = options that can be exercised before maturity

European option = options that can be exercised on a specific expiry

date

Answer:

Any factor that could cause the underlying stock’s value to ___drop___would
lead to early exercise. For example, the payment of a large unexpected
dividend or the possibility of an unexpected negative event (expectation of
stock $ will decrease).

1. Expectation of stock price will decrease

2. Payment of a large unexpected dividend

For instance, 你的 X=10 （maturity at 11 月）， 你知道票 S 会从 13 掉去

10（在 10 月）。since 你的 call 可以 exercise 在 11 月前， 你可以快快
exercise 掉不粗要等到 11 月。

7. Briefly explain the difference in risk taken by the buyer and seller of an
option.

Answer:

___Buyers___of options have limited risk because they can lose no more
than the option premium.

Option ___sellers___do not have limited risk because they must be prepared
to take up the opposite futures position, if and when the option is exercised.
Their risk position is more like that of the holder of an ordinary futures
contract, except that the seller of an option earns the __premium____.
8. Consider a stock priced at RM10 with a standard deviation of 30%. The
risk-free rate is 0.05. There are put and call options available at exercise
prices of RM10 and a time to expiration of six months. The calls are priced at
89 sen and the puts cost 25 sen. There are no dividends on the stock and the
options are European. Assume that all transactions consist of 1,000 shares or
one contract (1,000 options). Use the information to answer the questions
below.

a. What is your profit if you buy a call, hold it to expiration and the stock
price at expiration is RM17?

Call cost

= 89 sen x 1000 options

=RM890

Expiry

= (RM17 - RM10) X 1000 options

= RM7000

Profit

= RM7000 - 890

= RM6110
 Profit /
Loss Long
Call
Profit =
X=
Premi 0 6.11
S
10
um 0.
89 Premi
S=1um =
X = exercise price 7 0.89
S = underlying asset
price
b. What is the break-even stock price on the transaction?

Break-even stock price = $10.89- buy at $10 = $0.89 profit per share

Breakeven

= RM10+0.89

= RM10.89

Total: _0.89__x 1000 shares 890

Minus Premium 0.89 x 1000 = – 890

$0

Profit /
Loss Long
Call

X=
Premi 0 10 S
um 0.
89 0.
89
X = exercise price S=1
S = underlying asset 0.89
price
C. What is the maximum profit on the transaction described in part (a)?

Answer: Unlimited Profit since it is a long call

D. What is the maximum profit that the writer of the call can make?

Answer:

Maximum profit that the writer of the call can make is the PREMIUM

0.89 x 1000 options = RM890

9. An option has a time premium of 0.13. Its exercise price is RM5.50, the
underlying stock price is now RM5.80. What should be the option’s premium
be if it were:

a. (i) a call option?

Call option has intrinsic value only if strike price is smaller than spot price,
in the money.

Premium

= （Spot Price - Exercise Price) + Time Value

= (RM5.80 - RM5.50) + RM0.13

= RM0.43

Profi
t/ Lo
Loss ng
X= CaS
Pre 0 5. ll
miu 0 50
m . S=
4
Premium 5.8
3
= (5.80-5.50) + 0
X= Exercise
0.13 = RM0.43
Price
S= Price of
Underlying
B. (i) a put option?
Asset
Put option has intrinsic value only if strike price is greater than spot price,
in the money. In this case, the strike price is smaller than the spot
price, hence it is 0 intrinsic value, out-of-money.

Premium

= （Spot Price - Exercise Price) + Time Value

= (0) + RM0.13
 = RM0.13

Pro
fit/ Lo
Los ng
X S
Pre s0 P =
miu 0 ut 5.
m .
5 S=
1
Premium 5.
= (0)3 + 0.90 0 80
X= Exercise
= RM1.40
Price
B. Why areS=the premiums
Price of different?
___callUnderlying
option___is in-the-money but the ___put option___is out-of-the-
Asset
money. So, ___put option___IV is zero.

10. Why are several options of the same maturity and underlying asset but of
different exercise prices traded simultaneously?

Answer:

Exchange would list at least one __in-the-money____, one ___at-the-

money___and one ___out-of-the-money___option for trading at any time.
Additionally, options of various exercise prices will be demanded by
participants in order to establish different strategies.

1) Same maturity

2) Same asset

But why different exercise price?

1) In the money

2) At the money

3) Out of the money

4) Other prices (come from different demand)