Chapter 10 (WEEK 6)

Problem 10.8.

- If early exercise is not possible, it can be argued that two portfolios with the same value at

time T must also have the same value at earlier periods. The argument can’t be made when

early exercise is feasible.

Suppose that P + S > C + Ke-rT

There isn't an arbitrage opportunity in this scenario. We do not know when the put will be

exercised, so even if we buy the call, short the put, and short the stock, we cannot guarantee

the outcome.

Problem 10.9.

- The lower bound is calculated as:

= 80 - 75e-0.1 x 0.5 = $8.66

Problem 10.10
- The lower bound is calculated as:

= 65e-0.05 x 2/12 - 58 = $6.46

Problem 10.11.

- The present value of the strike price is calculated as:

60e-0.12 x 4/12 = $57.65

The present value of the dividend is

0.80e-0.12 x 1/12 = $0.79

Because 5 < 64 - 57.65 - 0.79, the condition in equation is

violated. An arbitrageur ought to short the stock and purchase the option. That generates 64 – 5 =

$59. To pay the $0.80 dividend in a month, the arbitrageur invests $0.79 of this at a rate of 12%

for a month. For four months, the remaining $58.21 is invested at a rate of 12%. Whatever

happens, a profit will be realized. The arbitrageur loses the $5 they invested in the option but

earns from the short position if the stock price falls below $60 in four months. When the stock

price hits $64, the arbitrageur shorts the shares and must pay $0.79 in dividends. The arbitrageur

closes the short position when the stock price is $60 or below. The short position produces at

least 64 – 57.65 – 0.79 = $5.56 in present value terms since $57.65 is the present value of $60.

Thus, the arbitrageur's gain has a present value of at least 5.56 – 5.00 = $0.56. The option is

exercised if, at expiration, the stock price is more than $60. In four months, the arbitrageur

finishes off the short position by purchasing the shares for $60. The $60 paid for the shares has a
current value of $57.65, and the dividend has a present value of $0.79 as before. Hence, the exact

profit from the short position and option exercise is 64 – 57.65 − 0.79 = $5.56. In terms of

present value, the arbitrageur's gain is 5.56 – 5.00 = $0.56.

Problem 10.12.

- The present value of the strike price in this case is

50e-0.06 x 1/12 = 49.75

Because 2.5 < 49.75 – 47, the condition in equation p ≥ max(Ke -rT - S0, 0) is violated. An

arbitrageur ought to purchase the stock, buy the put option, and borrow $49.50 at 6% for

one month. In every case, this can make a profit. The option expires worthless if the stock

price rises above $50 in one month, but the shares can still be sold for at least $50. The

current present value of $50 received in a month is $49.75. As a result, the approach makes

money with a present value of at least $0.25. The put option is exercised and the owned

stock is sold for precisely $50 (or $49.75 in terms of present value) if the stock price falls

below $50 one month. As a result, the trading method makes a precise $0.25 profit in terms

of present value.

Problem 10.13.

- When the interest earned on the strike price exceeds the lost insurance element,

exercising an American put early makes sense. The value of the interest collected at the
 strike price rises in response to an increase in interest rates, which makes early exercise

more attractive. The insurance element loses value as volatility decreases. This increases

the appeal of early exercise.

Problem 10.14.

- Using the put-call parity equation, we have

c + Ke-rT + D = p + S₀

or p = c + Ke-rT + D - S₀

From the information in the question, we have

p = 2 + 30e-0.1 x 6/12 + (0.5e-0.1 x 2/12 + 0.5e-0.1 x 5/12) - 29 = 2.51

Therefore, the price of a European put option that expires in six months and has a strike price

of $30 is $2.51

Problem 10.15.

- In comparison to the call price, the put price is too high if it is $3.00. An arbitrageur ought

to short the stock, short the put, and purchase the call. This produces $30 in cash (−2 + 3

+29 =$30), which is invested at a 10% rate. A profit with a locked-in present value of 3.00

– 2.51 = $0.49 is made regardless of what occurs.

The put option expires worthless and the call option is exercised if the stock price rises

above $30 in six months. The call option makes it possible to purchase the stock for $30,

or in present value terms, 30e-0.10 x 6/12 = $28.54. The present value of the dividends on the

short position is 0.5e-0.1 x 2/12 + 0.5e-0.1 x 5/12 = $0.97. This results in a profit of 30 – 28.54

−0.97 = $0.49.

The put option is exercised and the call option expires worthless if the stock price is less

than $30 in six months. The stock is purchased for $30 as a result of the short put option,

or 30e-0.1 x 6/12 = $28.54 in present value terms. The present value of the dividends on the

short position is 0.5e-0.1 x 2/12 + 0.5e-0.1 x 5/12 = $0.97. This results in a profit of 30 – 28.54

−0.97 = $0.49.