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CH 12
CH 12
2. Before the expiration of a call option, if its intrinsic value is $12.50 and the market value of
the option is $20, what is the time value of the option? What do we call the market value of the
option?
A. $32.50; option premium.
B. $7.50; option premium.
C. $32.50; option price
D. $7.50; option price
Level of difficulty: Medium
Solution: B
Time value = Market value – Intrinsic value = $20 – $12.5 = $7.5
The market value of the option is usually called option premium, not option price.
We can rewrite it as
This means that you could create a loan by doing the following: Long a put, long the
underlying asset, and short a call.
6. What is the intrinsic value (IV) of the following put? Underlying asset price (S) = $45, strike
price (X) = $40. What is the intrinsic value (IV) if it is a call?
A. $0, $5
B. $5, $0
C. $5, $5
D. $0, $0
Level of difficulty: Medium
Solution: A
IVPut = Max(X – S, 0) = Max[(40 – 45), 0] = 0
IVCall = Max(S – X, 0) = Max[(45 – 40), 0] = 5
8. What is the hedge ratio (h) given the following? PU = $55, PD = 48, Strike price (S) = $45.
A. 1.95
B. 2.05
C. 2.33
D. 2.50
Level of difficulty: Difficult
Solution: C.
13. You are in the process of interviewing for a promotion at the Absent Minded Profs and have
to identify the type of security based on the payoff diagram. All options expire on January
15th, 200x and the underlying asset is the index. Match the series from the diagrams to the
appropriate security and position.
Position Series
A Long Index
B Short Index
C Long Call
D Short Call
E Long Put
F Short Put
G Long Bond
H Short Bond
Diagrams:
14. Once again The Scatter Brained Brokers have provided the Absent Minded Profs with
incomplete information and, again, it is your job to fill in the missing information in the table
below:
At expiration
Long Value of Value of Payoff
Call Strike Profit
or option underlying (intrinsic
or Put price (loss)
Short today asset value)
Long Call 100 2.50 110
Short Call 100 2.50 110
Long Put 100 2.50 95
Short Put 100 2.50 95
Long Call 120 2.50 105
Short Call 120 2.50 105
Long Put 120 2.50 130
At expiration
Long Value of Value of Payoff
Call Strike Profit
or option underlying (intrinsic
or Put price (loss)
Short today asset value)
Long Call 100 2.50 110 10 7.50
Short Call 100 2.50 110 -10 (7.50)
Long Put 100 2.50 95 5 2.50
Short Put 100 2.50 95 -5 (2.50)
Long Call 120 2.50 105 0 (2.50)
Short Call 120 2.50 105 0 2.50
Long Put 120 2.50 130 0 (2.50)
Short Put 120 2.50 130 0 2.50
15. Mr. Cabinet, your boss at the Absent Minded Profs, prefers to have his information presented
visually. At his request, graph the payoffs (intrinsic values) and profits at expiration for the
following option investments.
A. Long Call, strike = $55, cost today = $10
B. Short Call, strike = $55, cost today = $10
C. Long Put, strike = $55, cost today = $10
D. Short Put, strike = $55, cost today = $10
Level of difficulty: Easy
Solution:
XCT
Price Price Strike Risk
stock
of call of put price Free rate
price
A 100 7 95 3%
B 150 30 130 5%
C 3 2 15 6%
D 5 5 25 10%
E 75 25 34 90
F 130 25 20 5%
Call
S X r T
value
A 100 98 2% 0.03 1
B 100 98 2% 0.04 1
C 100 98 3% 0.03 1
D 100 99 2% 0.03 1
E 100 98 2% 0.03 .3
F 99 98 2% 0.03 1
Call
S X r T
value
A 100 98 2% 0.03 1 1.3551 1.3251 0.9123 0.9074 96.0595 4.0634
B 100 98 2% 0.04 1 1.0251 0.9851 0.8473 0.8377 96.0595 4.2640
C 100 98 3% 0.03 1 1.6884 1.6584 0.9543 0.9514 95.1037 4.9534
D 100 99 2% 0.03 1 1.0167 0.9867 0.8453 0.8381 97.0397 3.2057
E 100 98 2% 0.03 .3 1.6029 1.5864 0.9455 0.9437 97.4138 2.6244
F 99 98 2% 0.03 1 1.0201 0.9901 0.8462 0.8389 96.0595 3.1819
18. QBV, a non-dividend paying stock, is currently trading for $100 a share. There is a 25
percent chance that the stock will trade for $85 in one year and a 75 percent chance that the
price will increase to $135. The risk free rate is 5 percent per year. All options expire in one
year.
B. To determine the price of the put, we will use the put-call parity condition:
19. Briefly state all the factors that affect the value of a call option and a put option.
Level of difficulty: Medium
Solution:
Call option prices are positively related to the price of the underlying asset, the volatility of
the price of the underlying asset, the time to expiration, increase in interest rates, but
negatively related to the strike price and the dividend payment of the underlying asset. Call
option prices approach their intrinsic value for deep in and deep out of the money calls.
Put option prices are positively related to the strike price, time to expiration, dividend
payments (as dividend payments increase, put prices increase), and the volatility of the
underlying asset price.
Put option prices are negatively related to the underlying asset price and interest rates.
20. Does put-call parity hold for the following? R f = 5%, P0 = $10.50, C0 = $ 8, Stock price (S) =
$25, t = 4, strike price (X) = 32. If not, what is the put price according to put-call parity,
assuming the others are correct?
Level of difficulty: Medium
Solution:
21. Briefly explain “the Greeks” delta, theta, vega, and rho, in option pricing.
Level of difficulty: Medium
Solution:
Delta (Δ) is the change in the price of the option with the change in the underlying asset
price.
Theta (θ) is the change in the option value with time.
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Vega is the change in the option value with respect to the volatility of the underlying asset.
Rho (ρ) is the change in the option value with respect to a change in the interest rate.
22. What is the call price (C) given the following information: S = $36, X = $32. r = 5%. t = 2
years. σ= 20%
Level of difficulty: Medium
Solution:
23. In Problem 22, if the time value is $4.50, calculate the intrinsic value.
Level of difficulty: Medium
Solution:
Intrinsic value = Premium – Time value = 8.1964 – 4.50 = $3.70
24. Your boss has observed that the call options on XCT and BRG are trading at different prices.
Both options have the same strike price and the same time to expiration. Provide two possible
explanations for this observation.
Level of difficulty: Medium
Solution:
Possible explanations:
The two stocks have different risks. The price of a call, holding all else equal, increases
with risk.
The prices of the two stocks are different. Call prices increase with the price of the
underlying asset.
The dividend payments of the two stocks are different. Call prices decrease as dividend
payments increase.
25. Mr. Cabinet is also interested in the payoffs to combinations of options. Graph the intrinsic
values of the following portfolios (all options expire on the same day and are written on the
same, non-dividend paying, underlying asset):
A. Long 1 call, strike = $25; long 1 put, strike = $20
B. Short 1 call, strike = $25; long 1 put, strike = $15
C. Long 1 call, strike = $25; short 1 put, strike =$25
D. Long 1 call, strike = $25; short 1 share of underlying asset
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E. Long 1 call, strike = $25; short 1 share; $25 in cash
F. Long 1 put, strike = $25; long 1 share; short $25 in cash (i.e. Repay loan)
Level of difficulty: Medium
Solution:
The portfolio:
Note: the value of the portfolio is the same as being long a share
Note: the portfolio graph is the same as the payoff diagram for a call.
26. You have observed that a very smart and successful investor has bought a call and a put on
the S&P/TSX index. The options have the same strike prices and expire on the same day.
To understand what the investor is thinking we need to determine when the portfolio of 1 call
and 1 put will be profitable. Below is the graph of the payoffs (assuming that the strike price
is $25 for convenience).
Examining the payoff diagram, we see that the portfolio only makes money if the value of the
S&P/TSX is above or below the strike price. Therefore, the investor is expecting the
S&P/TSX to be either above or below the strike price—essentially, she is expecting volatility
in the market.
27. QBV, a non-dividend paying stock, is currently trading for $100 a share. There is a 25
percent chance that the stock will trade for $85 in one year and a 75 percent chance that the
price will increase to $135. The risk free rate is 5 percent per year. All options expire in one
year.
A. If the call option on QBV with a strike of $115 is actually trading for $10, show that there
is an arbitrage opportunity.
B. If the put option on QBV with a strike price of $98 is actually trading for $0.50, show that
there is an arbitrage opportunity.
Level of difficulty: Medium
Solution:
A.
If we buy one share, borrow the present value of the down price and sell 2.5 calls, we get a
positive cash flow today and a zero cash flow no matter what happens in the future. This is a
classic example of arbitrage.
B.
Cash flow Future value
Action
today of stock
$85 $135
Buy stock -100.00 85 135
Borrow PV(135) 128.57 -135 -135
Buy 3.8462 puts -1.92 50 0
Total cash flows $26.65 0 0
If we buy one share, borrow the present value of the up price and buy 3.8462 puts, we get a
positive cash flow today and a zero cash flow no matter what happens in the future. This is a
classic example of arbitrage. To determine the number of puts: with the stock and the bond
we have a cash flow of $50 if the stock price is $85 and zero otherwise. Each put will pay
$13 if the stock price is $85 and zero otherwise. Therefore, we need 3.8462 puts to have a
cash flow of $50 in the down state.
28. QBV, a non-dividend paying stock, is currently trading for $100 a share. There is a 25
percent chance that the stock will trade for $85 in one year and a 75 percent chance that the
price will increase to $135. The risk free rate is 5 percent per year. All options expire in one
year. You would like to purchase a call with a strike of $125. Unfortunately it is not available
on the market so you will have to create it synthetically. Design a portfolio to create a call
with a strike of $125 and demonstrate that it will give the same payoffs as the desired call.
Level of difficulty: Medium
Solution:
To solve this problem, we need to first determine the desired cash flows (i.e. What would the
cash flows be if we owned a call with a strike price of $125?).
The portfolio of a stock and a short bond gives us the same pattern as the call; however, it
pays $50 in the up state not $10. So if we buy 1/5 of a stock and borrow 1/5 of $80.95, we
will have the same payoffs as the desired call.
We see from the above table that the proposed portfolio of long 1/5 of a share and short 1/5
of the PV(85) will exactly replicate the cash flows from the desired call option. The cost of
the replicating portfolio is $3.81 (the cash flow is negative meaning that you will be paying
$3.81 to acquire the portfolio).
29. DPG, a non-dividend paying stock, is currently trading for $200 a share. There is a 30
percent chance that the stock will trade for $150 in one year and a 70 percent chance that the
price will increase to $250. The risk free rate is 5 percent per year. There is a one year call
with a strike price of $235.
A. What is the price of the call?
B. What is the delta of the call? Define and calculate.
Level of difficulty: Medium
Solution:
B. The delta measures the change in the value of the option for a change in the value of the
stock. In the above case, if the price of the stock goes up $1, we see that the price of the call
will increase by S/h or $0.15.
30. Calculate the put price (P) according to the put-call parity, given the information in Problem
22.
Level of difficulty: Difficult
Solution:
Using put call parity:
Note that the risk free rate used in the Black-Scholes model is continuously compounded.
At expiration
Value Payoff
Call Value of In/Out
Long or Strike of (intrinsic Profit
or underlying of the
Short price option value of (loss)
Put asset money
today option)
A Long Put 80 .05 -.05
B Long Call 80 2.00 -1
C Short Put 80 .05 -.05
D Short Call 80 .05 -.05
E Long Call 1.00 125 25
F Short Put 124 125 -1 1
G 25 2.00 95 0 -2
H 25 2.00 95 70 68
I Call 75 90 2
J Put 75 90 2
K Call 75 5.00 90 -10
L Put 75 90 -2
M Short Call 110 0 2
N Put 80 3.00 -25 -22
At expiration
Value Payoff
Call Value of In/Out
Long or Strike of (intrinsic Profit
or underlying of the
Short price option value of (loss)
Put asset money
today option)
A Long Put 80 .05 80 At 0 -.05
B Long Call 80 2.00 81 In 1 -1
C Short Put 80 .05 79 In -1 -.05
D Short Call 80 .05 81 In -1 -.05
E Long Call 99 1.00 125 In 26 25
F Short Put 124 2.00 125 In -1 1
G Long Put 25 2.00 95 Out 0 -2
H Long Call 25 2.00 95 In 70 68
I Long Call 75 13.00 90 In 15 2
J Short Put 75 2.00 90 Out 0 2
K Short Call 75 5.00 90 In -15 -10
L Long Put 75 2.00 90 Out 0 -2
M Short Call 110 2.00 110 At 0 2
N Short Put 80 3.00 55 In -25 -22
32. Mr. Ken Fused, one of your clients, has been reading his daughter’s finance text book and has
a question about options. He says: “If I buy a call option, I have the right to buy the asset at
the strike price. If I buy a put option, I have the right to sell the asset at the strike price; and if
I sell a put, I have to buy the asset at the strike price. Therefore, buying a call option is the
same as selling a put. So if I observe that puts and calls have different prices, I can make
Mr. Fused is confusing long and short option positions. The holder of a call option has the
choice of exercising the call and will only do so if the price of the stock is greater than the
strike price. In contrast, the seller of the put will HAVE to buy the stock from the holder
when the holder chooses. The holder of the put will only choose to exercise when the stock
price is less than the strike price.
Payoffs
Long Call Short Put
S>X >0 0
S=X 0 0
S<X 0 <0
Given the differences in the pattern of payoffs, there is no reason to require the price of a put
and a call to be the same.
33. Xiang Zhu, a client of the Absent Minded Profs, has phoned you with a question. She has
been reading a finance text and can’t understand how to use the binomial option pricing
model to value a call option. The underlying stock is currently trading for $100, and there is a
30 percent chance that it will increase to $190 and a 70 percent chance that it will fall to $85
in one year. The risk free rate is 10 percent. There is a call option with a strike price of $170
which, according to the binomial model, should have a value of $4.3290. What has confused
Xiang is the following: there is a 30 percent chance that the call will be worth $20 and a 70
percent chance that it will be worth zero so the expected value should be $6. Why is it
only worth $4.3290?
A. Demonstrate that if the call was trading for $6, there would be an arbitrage opportunity.
B. Calculate the risk neutral probabilities.
C. Calculate the expected present value of the call option using the risk neutral probabilities.
D. Why can we value options as if the investors are risk neutral?
Level of difficulty: Difficult
Solution:
A.
Cash flow Future value
Action
today of stock
If we buy the stock, borrow $77.27 and sell 5.25 calls, we will have a positive cash flow
today and zero no matter what happens in the future – this is arbitrage. Everyone will start
doing this transaction and the price of the stock, risk free rate and the price of the call will
adjust until the arbitrage opportunity is gone.
B. The risk free rate is 10%, so if we invest $100 we expect to have $110 in one year. Using
the up and down prices, we solve for the risk neutral probabilities:
The risk neutral probability of the down state is 76.19% and the risk neutral probability of the
up state is 23.81%.
C. Using the risk neutral probabilities, we obtain the expected value of the call option in one
year:
D. The price of the option is based on an arbitrage argument which is, by definition,
independent of risk aversion so we need to use the risk-neutral probabilities.
34. You have just been appointed manager of the equity portfolio of a large pension plan. The
portfolio has a current value of $100 billion and is well diversified and consequently has a
beta close to one. The trustees of the pension plan are very risk averse and in order to prevent
you from taking on too much risk, they have structured your compensation as follows: if the
value of the fund drops below $90 billion in one year, you will be fired with no severance
pay. If the fund is between $90 billion and $120 billion, you will be paid $2 million + 0.01
percent of the difference between the fund value and $90 billion (i.e., If the fund is worth $95
billion in 1 year, you will be paid $2 million + $500,000 = $2.5 million). If the fund is worth
more than $120 billion, your salary will be capped at $5 million. You are allowed to invest in
options on the S&P/TSX. The current value of the S&P/TSX is 1,000 and there are puts and
calls traded which expire in one year. The puts and calls both have multipliers of $100. The
standard deviation of returns on the S&P/TSX is 10 percent per year and the risk free rate is 3
percent per year. Assume no dividends for both the portfolio and the S&P/TSX, and that the
options are European.
S X r T Call value
1000 900 3% 0.1 1 1.4036 1.3036 0.9198 0.9038 130.3881
1000 1200 3% 0.1 1 -1.4732 -1.5732 0.0703 0.0578 2.9962
Using put-call parity, we find that the value of the put with a strike of $900 is $3.7891
With the $100 multiplier and an index value of 1,000, each option will protect $100,000 of
value. As the portfolio has a value of $100 billion, we will need to use 1 million puts and
calls.
The cost of the puts: $3.7891 million. The proceeds of the sale of the calls: $2.9962 million.
The total impact on the portfolio is a cost of $792,900.
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Copyright © 2008 by John Wiley & Sons Canada, Ltd. or related companies. All rights reserved.
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