University of Toronto

Rotman School of Management

MGT 337Y PROBLEM SET #5

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1. Options
You observe the prices of two European calls on the same underlying asset:
Call 1: strike price: $100, maturity: 1 year, price (at date 0): 120$
Call 2: strike price: $200, maturity: 1 year, price (at date 0): 25$
You can borrow and lend money at the 10% risk-free rate. Do the prices above offer an
arbitrage opportunity? If they do, describe precisely your arbitrage strategy.

2. Forward contracts
The spot price of an ounce of gold at date 0 is $2,000. The risk-free interest rate is 5%
per year. Today, the forward price of gold (for contracts with one-year maturity) is
$2,115 per ounce.
a) Show that this price offers an arbitrage opportunity, and describe precisely the
arbitrage strategy you can use to take advantage of this opportunity.
b) Assume that, in addition to the previous hypotheses, you have to pay a storage cost for
the gold you buy and plan to keep until the maturity of the forward contract. This storage
cost is $14.285 per ounce, and is paid when the gold is bought. Does this change your
previous answer?
c) You can still buy small quantities of gold and keep them at your place, which cancels
the storage cost. However, you cannot borrow and lend money at the same interest rate.
Assume you can borrow money at 5.8%, and lend money at 4.8%. Show that under these
hypotheses, any forward price between $2,096 and $2,116 is acceptable.
d) Finally, assume the storage cost of gold is 0, and the interest rate is 5.75% (to lend and
borrow money). Assume that all the hypotheses of CAPM are satisfied. The β coefficient
of gold is 0.1, and the market risk premium is 2%. If the forward price of gold is $2,115
per ounce, and if the market is in equilibrium, what spot price in one year do investors
anticipate?

3. Options
A stock price is currently $100. In any year, the price can increase by a factor of 1.20, or
fall by a factor of 0.80. The stock pays no dividends. The risk-free rate is 10%.
a) Find the value of a European call option on this stock with a strike price of $100 and a
maturity of 2 years.
b) Find the value of a European put option on this stock with a strike prices of $100 and
a maturity of 2 years.
c) If the two options above were American instead of European, would it be optimal to
exercise any of them early? Find the values of these two options if they were American.
d) Is the put-call parity relation satisfied by the European options?
4. Options
XXX Inc.’s current stock price is $100 and it can move up or down over the next two
periods as shown below.

Time 0 Time 1 Time 2

$144
$120
$100 $96
$80
$64

The risk-free interest rate is 6% per period and each period is one year. The stock pays
no dividends prior to period 2.
a) What is the risk-neutral probability? At each node in the tree, calculate the price of an
American call with a strike price of $90 and expiration at time 2.
b) What would be the value of the call option at time 0, if it had been a European rather
than an American call option?
c) At each node of the tree, compute the price of an American put option with a strike
price of $100 and expiration at time 2.
d) Ignore information provided above. Assume you want to sell XXX’s put options to
investors and buy call options. You intend to sell one put option and buy one call option,
both with a strike price of $50 and maturing in one period. Design a strategy using a
combination of XXX’s stock and risk-free bonds that can hedge the risk you would have
from selling one put option and buying one call option? Be precise by stating what
securities you should buy or sell.

5. Option to abandon
WOE is currently considering whether to acquire a two year lease over a gold deposit
from a local government in Southeast Asia. At the end of the lease, all rights to the
property revert to the government. The deposit is estimated to contain 120,000 ounces of
gold. Mining would involve a one-year development phase with a cost of $10 million
payable at the beginning of the lease. WOE can subcontract the extraction process of
gold to a subcontractor. The cost of extraction is $450 per ounce to be paid one year from
the beginning of the lease. WOE can sell the gold at the spot price one year from the
beginning of the lease. Assume gold price follows a lognormal distribution with a mean
parameter µ=0.07 and standard deviation of σ= 0.20. The current gold price is $500 per
ounce. The continuously compounded risk free rate is 5% and the required return for the
mining project is 10%. What is the value of the lease without considering the option to
abandon the project in one year? What is the value of the lease with the option to
abandon?
(Hint: if gold price S has a lognormal distribution, then E(ST) = S0eµT, where S0 is gold
price at time 0 and E(ST) is the expected value of gold price at time T. )