Financial Derivatives – ESCE 4th year

Exercises and problems / Chapter 4

1) Intrinsic and time values of options

On November 9th N share A quoted 16.63 € and hereafter were the premiums of options share A.

Strike CALL PUT

Dec N Jan N+1 Dec N Jan N+1
15.63 1.51 1.69 0.30 0.48
16.12 1.17 1.35 0.43 0.65
16.61 0.84 1.05 0.61 0.84
17.1 0.57 0.80 0.83 1.07
17.59 0.36 0.59 1.12 1.35

Calculate intrinsic values and time values of these options on November 9th.

The intrinsic value is the gain that you could make by deciding to exercise with profit (from exercising with
profit the option at the current price of underlying):
- For the CALL it is max {16.63 − K , 0} where K is the strike
- For the PUT it is max { K − 16.63, 0} where K is the strike.
Below is the table displaying intrinsic values for each option.

Strike CALL PUT

Dec N Jan N+1 Dec N Jan N+1
15.63 1 1 0 0
16.12 0.51 0.51 0 0
16.61 0.02 0.02 0 0
17.1 0 0 0.47 0.47
17.59 0 0 0.96 0.96

The time value is the remaining value of the option or the premium - intrinsic value:
- For the CALL it is premium − max {16.63 − K , 0}
- for the PUT it is premium − max { K − 16.63, 0} .
Below is the table displaying time values for each option.

Strike CALL PUT

Dec N Jan N+1 Dec N Jan N+1
15.63 0.51 0.69 0.3 0.48
16.12 0.66 0.84 0.43 0.65
16.61 0.82 1.03 0.61 0.84
17.1 0.57 0.8 0.36 0.6
17.59 0.36 0.59 0.16 0.39

2) Elementary position on options (call)

a) On October 20th N an investor buys one European call maturity January N+1 on a stock for 3€. The strike
price is 40€. Write the mathematical expression of the payoff of this position with respect to stock price at
expiration date and plot its graph.

1
 Payoff
46 (€)

46

50 S (€)
0

-4

b) On November 20th N an investor opens a short position (writes) on one European put maturity January
N+1on a stock for 4€. The strike price is 50€. Write the mathematical expression of the payoff of this
position with respect to stock price at expiration date and plot its graph.

payoff = 4 − max {50 − S , 0}

If S < 50, payoff = 4 – (50-S) = S – 46 : upward sloping line starting at (0; -46) and ending up at (50; 4)
If S > 50, payoff = 4

Payoff
4
40
0
50 S (€)

46

-46

4) Elementary position on options

a) On November 24th N an investor buys one American call maturity February N+1 on a stock for 2€. The
strike price is 50€. Write the mathematical expression of the payoff of this position with respect to stock
price at expiration date and plot its graph.

Payoff = max{S-50} - 2
If S < 50, payoff = -2
If S > 50, payoff = S -50 -2 = S – 52 : : upward sloping line starting at (50; -2) and crossing up the horizontal
axis at (52; 0)

Payoff (€)

52

50 S (€)
0
-2

3
 payoff = max {S − 40, 0} − 3
If S < 40, payoff = -3
If S > 40, payoff = S -40 -3 = S – 43 : upward sloping line starting at (40; -3) and crossing the horizontal
axis at (43; 0).

Payoff (€)

43

40 S (€)
0
-3 50

b) On October 20th N an investor sells (writes) one European call maturity January N+1 on a stock for 3€.
The strike price is 40€. Write the mathematical expression of the payoff of this position with respect to
stock price at expiration date and plot its graph.
payoff = 3 − max {S − 40, 0}
If S < 40, payoff = 3
If S > 40, payoff = 3 – (S-40) = 3+ 40 - S = 43-S : downward sloping line starting at (40; 3) and crossing
the horizontal axis at (43; 0).

Payoff (€)

43

3 S (€)

30 40 50 60

3) Elementary position on options (put)

a) On November 20th N an investor opens a long position on one European put maturity January N+1on a
stock for 4€. The strike price is 50€. Write the mathematical expression of the payoff of this position with
respect to stock price at expiration date and plot its graph.
payoff = max {50 − S , 0} − 4
If S < 50, payoff = (50-S) -4 = 46 – S : downward sloping line starting at (0; 46) and ending up at (50; -4).

If S > 50, payoff = -4

2
b) On November 24th N an investor sells (writes) one American call maturity February N+1 on a stock for
2€. The strike price is 50€. Write the mathematical expression of the payoff of this position with respect to
stock price at expiration date and plot its graph.
Payoff = 2 - max{S-50}
If S < 50, payoff = 2
If S > 50, payoff = 2 – (S-50) = 2+ 50 - S = 52-S : downward sloping line starting at (50; 2) and crossing
up the horizontal axis at (52; 0)

Payoff (€)

52

2 S (€)

50

c) On November 25th N an investor opens a long position on one American put maturity February N+1on
a stock for 2€. The strike price is 40€. Write the mathematical expression of the payoff of this position with
respect to stock price at expiration date and plot its graph.
Payoff = max{40-S,0} - 2
If S < 40, payoff = (40-S) -2 = 38 – S : downward sloping line starting at (0; 38) and ending up at (40; -2)

If S > 40, payoff = -2

Payoff
38

38

40 S (€)
0

-2

d) On November 25th N an investor opens a short position (writes) on one American put maturity February
N+1on a stock for 2€. The strike price is 40€. Write the mathematical expression of the payoff of this
position with respect to stock price at expiration date and plot its graph.
Payoff = 2 - max{40-S,0}
If S < 40, payoff = 2 – (40-S) = S – 38 : upward sloping line starting at (0; -38) and ending up at (40; 2)
If S > 40, payoff = 2

4
 Payoff
(€)
2

0
40 S (€)

38

-38

5) Structuring a protective put strategy

On October 20th N an investor buys 100 shares of stock PotiLtd for 20 EUR per share. Plot the payoff
pattern for that portfolio with respect to the possible share price evolution S.
The payoff for a “non-protected” portfolio can be written as
payoff = 100 × ( + S − 20 ) = 100S − 2000
We can plot the payoff as below

Payoff
(€)
20
0 S (€)

-2000

On October 21st the same investor takes a long position on 100 puts on PotiLtd strike price 18 EUR maturity
January N+1. The put premium is 0.50 EUR.
Write the mathematical expression and plot the payoff pattern for the adjusted portfolio with respect to the
possible share price evolution S.

The payoff for a “protected” portfolio can be written as

payoff = 100 × ( + S − 20 ) + 100 × ( max {18 − S , 0} − 0.50 ) = 100S + 100 × max {18 − S , 0} − 2050
5
If S < 18, we have (18-S)>0 then payoff = 100S + 100×(18 – S) -2050 = -250
If S > 18, we have (18-S)<0 then payoff = 100S -2050 : upward sloping line starting at (18; -250) and
crossing the horizontal axis at (20.5; 0)

Payoff
(€)
18 20
0 S (€)
20.5

-200

-250

-2000

The blue plot indicates the payoff for the “non protected” portfolio.
The red plot indicates the payoff for the “protected” portfolio.

6) Structuring a Straddle
On November 20th N one buys one call maturity January N+1 strike 45€ and one put maturity January N+1
same strike and same underlying. The call premium is 3€ and the put premium is 4€.
a) Write the mathematical expression of the payoff of this strategy with respect to stock price at expiration
date and plot its graph.

payoff = max {S − 45, 0} − 3 + max {45 − S , 0} − 4 = max {S − 45, 0} + max {45 − S , 0} − 7

If S < 45, we have (S-45)<0 and (45-S)>0 then payoff = (45-S) -7 = 38 – S : downward sloping line starting
at (0; 38) and ending up at (45; -7)

If S > 45, we have (S-45)>0 and (45-S)<0 then payoff = (S-45) -7 = S – 52 : upward sloping line starting
at (45; -7) and crossing the horizontal axis at (52; 0)

6
 Payoff (€)

38

38 52
S (€)
30 35 40 45 50 55
0

-7
b) What kind of expectations is this strategy appropriate for?
This strategy is appropriate when expecting high volatility of the underlying asset price on both sides (below
38 or beyond 52 thresholds).

7) Structuring a Strangle
On November 20th N one buys one call strike 45€ and one put strike 40€ and same underlying. Both options
have the same expiration date or maturity January N+1. The call premium is 3€ and the put premium is 4€.
a) Write the mathematical expression of the payoff of this strategy with respect to stock price at expiration
date and plot its graph.
payoff = max {S − 45, 0} − 3 + max {40 − S , 0} − 4 = max {40 − S , 0} + max {S − 45, 0} − 7
If S < 40, we have (S-45)<0 and (40-S)>0 then payoff = (40-S) -7 = 33 – S : downward sloping line
starting at (0; 33) and ending up at (40; -7)
If 40 < S < 45, we have (S-45)<0 and (40-S)<0 then payoff = -7
If S > 45, we have (S-45)>0 and (40-S)<0 then payoff = (S-45) -7 = S -52 : upward sloping line starting at
(45; -7) and crossing the horizontal axis at (52; 0)

Payoff (€)

33

33 52
S (€)
30 35 40 45 50 55
0

-7
b) What kind of expectations is this strategy appropriate for?
This strategy is appropriate when expecting high volatility of the underlying asset price on both sides (below
33 or beyond 52 thresholds).

8) Structuring a butterfly spread

Hereafter are the quotes on November 23rd of the premiums of calls maturity January N+1 on a stock.

Strike in € Premium in €

7
 55 10
60 7
65 5

On November 23rd an investor buys a call strike 55€, a call strike 65€, and sells two calls strike 60€.
a) Write the mathematical expression of the payoff of this strategy with respect to stock price at expiration
date and plot its graph.
payoff = max {S − 55,0} − 10 + max {S − 65, 0} − 5 + 2 × ( 7 − max {S − 60,0}) = max {S − 55, 0} + max {S − 65, 0} − 2 max {S − 60, 0} − 1
If S < 55, we have (S-55)<0, (S-60)<0 and (S-65)<0 then payoff = -1

If 55 < S < 60, we have (S-55)>0, (S-60)<0 and (S-65)<0 payoff = (S - 55) -1 = S -56 : upward sloping line
starting at (55; -1) and ending up at (60; 4)

If 60 < S < 65, we have (S-55)>0, (S-60)>0 and (S-65)<0 payoff = (S - 55) -2(S - 60) -1 = 64 – S : downward
sloping line starting at (60; 4) and ending up at (65; -1)

If S > 65, we have (S-55)>0, (S-60)>0 and (S-65)>0 payoff = (S-55) + (S-65) -2(S-60) -1 = -1

Payoff (€)

+4
56
64 S (€)

55 60 65
-1

b) What kind of expectations is this strategy appropriate for?

This strategy is appropriate when expecting low volatility of the underlying asset price around 60.

9) Structuring a Strip
On November 23rd one buys one call strike 45€ and two puts with the same strike and same underlying.
Both options have the same expiration date or maturity January N+1. The call premium is 3€ and the put
premium is 4€.
a) Write the mathematical expression of the payoff of this strategy with respect to stock price at expiration
date and plot its graph.
payoff = max {S − 45, 0} − 3 + 2 × ( max {45 − S , 0} − 4 ) = max {S − 45, 0} + 2 × max {45 − S , 0} − 11
If S<45, we have (S-45)<0 and (45-S)>0 then payoff = -2(45-S) -11 = 79 – 2S : downward sloping line
starting at (0; 79) and ending up at (45; -11)

If S>45, we have (S-45)>0 and (45-S)<0 then payoff = (S-45) -11 = S -56 : upward sloping line starting at
(45; -11) and crossing the horizontal axis at (56; 0).

8
 Payoff (€)

39.5 56

35 45 55
0 S (€)

-11

The downward sloping line (slope -2) on the interval [0; 45] is twice steeper than the upward sloping line
(slope 1)on [45; ∞[.

b) What kind of expectations is this strategy appropriate for?

Expecting high volatility of stock prices, in a strip the investor is betting that there will be a big stock price
move and considers a decrease in the stock price to be more likely than an increase.

10) Structuring a Strap

On October 15th one buys two calls strike 45€ and one put same strike and same underlying. Both options
have the same expiration date or maturity December N. The call premium is 3€ and the put premium is 4€.
a) Write the mathematical expression of the payoff of this strategy with respect to stock price at expiration
date and plot its graph.
payoff = 2 × ( max {S − 45, 0} − 3) + ( max {45 − S , 0} − 4 ) = 2 × max {S − 45, 0} + max {45 − S , 0} − 10
If S<45, we have (S-45)<0 and (45-S)>0 then payoff = (45-S) -10 = 35 – S : downward sloping line starting
at (0; 35) and ending up at (45; -10)

If S>45, we have (S-45)>0 and (45-S)<0 then payoff= 2(S-45) -10 = 2S -100 : upward sloping line starting
at (45; -10) and crossing up the horizontal axis at (50; 0).

Payoff (€)

35

50

35 45 55
0

-10

The upward sloping line (slope 2) on the interval [45; ∞[ is twice steeper than the downward sloping line
(slope -1)on [0; 45].

b) What kind of expectations is this strategy appropriate for?

Expecting high volatility of stock prices, in a strap the investor is betting that there will be a big stock price
move and considers an increase in the stock price to be more likely than a decrease.