com,
In 2013 and prior years the SOA and CAS jointly administered Exam MFE/3F.
Starting in 2014 the SOA administered Exam MFE without the CAS.
How much detail is needed and how many problems need to be done varies by person and
topic. In order to help you to concentrate your efforts:
1. About 1/6 of the many problems are labeled highly recommended,
while another 1/6 are labeled recommended.
2. Important Sections are listed in bold in the table of contents.
Extremely important Sections are listed in larger type and in bold.
3. Important ideas and formulas are in bold.
4. A section of Important Ideas and Formulas.
5. A chart of past exam questions by Section.
My Study Guide is a thick stack of paper.1 However, many students find they do not need to look
at the textbook. For those who have trouble getting through the material, concentrate on
sections in bold.
Sections and material in italics should be skipped on the first time through.
Highly Recommended problems (about 1/6 of the total) are double underlined.
Recommended problems (about 1/6 of the total) are underlined.
Do at least the Highly Recommended problems your first time through.
It is important that you do problems when learning a subject and then some more
problems a few weeks later.
Be sure to do all the recent exam questions at some point.2
I have written some easy and tougher problems.3 The former exam questions are arranged in
chronological order. The more recent exam questions are on average more similar to what you will
be asked on your exam, than are less recent exam questions.
In the electronic version use the bookmarks / table of contents in the Navigation Panel
in order to help you find what you want. You may find it helpful to print out selected portions,
such as the Table of Contents and the Important Ideas Section.
My Practice Exams are sold separately. My Seminar Slides are sold separately.
1
The number of pages is not as important as how long it takes you to understand the material. One page in a
textbook might take someone as long to understand as ten pages in my Study Guides.
2
Unfortunately, there are only a few released exams, plus the sample exam questions.
3
Points in my study guides are based on 100 points = a 4 hour exam.
Questions on your exam are worth the equivalent of 2.5 points.
hmahler@mac.com,
The MFE CBT exam will provide a formula document as well as a normal
distribution calculator that will be available during the test by clicking buttons on
the item screen. Details are available on the Prometric Web Site. To try it out:
https://www.prometric.com/en-us/clients/SOA/Pages/calculator.aspx
Similar to other exam reference buttons, the normal distribution calculator button will be available
throughout the exam in the top right corner of every item screen. Click the button to call up the
calculator and calculate cumulative normal distribution and inverse cumulative normal distribution
values. Use these values to answer the question as needed.
When using the normal distribution calculator, values should be entered with five decimal places.
Use all five decimal places from the result in subsequent calculations.
The normal distribution calculator button replaces the Normal Table.
The previous rule on rounding no longer applies.4
You can try the normal distribution calculator button at the Prometric Web Site.
You will benefit from using it at least part of the time when you are studying.
The formula sheet contains the same information about the Normal and LogNormal distributions as
was provided in the past.
Besides many past exam questions from the CAS and SOA, my study guides include some
past questions from exams given by the Institute of Actuaries and Faculty of Actuaries in Great
Britain. These questions are copyright by the Institute of Actuaries and Faculty of Actuaries, and are
reproduced here solely to aid students studying for actuarial exams. These IOA questions are
somewhat different in format than those on your exam, but should provide some additional
perspective on the syllabus material.
I suggest you buy and try the TI-30XS Multiview calculator.
You will save time doing repeated calculations using the same formula.
The BA II Plus Professional calculator is useful for calculations involving interest.
Many people find it helpful to have both calculators during the exam.
Download from the SOA website, a copy of the tables to be attached to your exam.5
Read the Hints on Study and Exam Techniques in the CAS Syllabus.6
Read Tips for Taking Exams.7
4
Unfortunately, most of my solutions were written up using the prior rule: On Joint Exam 3F/MFE, when using the
normal distribution, choose the nearest z-value to find the probability, or if the probability is given, choose the
nearest z-value. No interpolation should be used. For example, if the given z-value is 0.759, and you need to find
Pr(Z < 0.759) from the normal distribution table, then chose the probability for z-value = 0.76:
Pr(Z < 0.76) = 0.7764.
This should not make a significant difference.
5
You will be supplied with information on the Normal and LogNormal Distributions.
6
http://casact.org/admissions/syllabus/index.cfm?fa=hints
7
http://www.casact.org/admissions/index.cfm?fa=tips
hmahler@mac.com,
Starting in Spring 2011, MFE/3F is 3 hours and given via Computer Based Testing (CBT).
While studying, you should do as many problems as possible. Going back and forth between
reading and doing problems is the only way to pass this exam. The only way to learn to solve
problems is to solve lots of problems. You should not feel satisfied with your study of a subject
until you can solve a reasonable number of the problems.
There are two manners in which you should be doing problems. First you can do problems in
order to learn the material. Take as long on each problem as you need to fully understand the
concepts and the solution. Reread the relevant syllabus material. Carefully go over the solution to
see if you really know what to do. Think about what would happen if one or more aspects of the
question were revised.8 This manner of doing problems should be gradually replaced by the
following manner as you get closer to the exam.
The second manner is to do a series of problems under exam conditions, with the items you will
have when you take the exam. Take in advance a number of points to try based on the time
available. For example, if you have an uninterrupted hour, then one might try either
60/2.5 = 24 points or 60/3 = 20 points of problems. Do problems as you would on an exam in
any order, skipping some and coming back to some, until you run out of time. I suggest you leave
time to double check your work.
Expose yourself somewhat to everything on the syllabus. Concentrate on sections and items in
bold. Do not read sections or material in italics your first time through the material.9 My chart of
where the past exam questions have been may also help you to direct your efforts.10
Try not to get bogged down on a single topic. On hard subjects, try to learn at least the simplest
important idea. The first time through do enough problems in each section, but leave some
problems in each section to do closer to the exam. Make a schedule and stick to it. Spend a
minimum of one hour every day. I recommend at least two study sessions every day, each of at
least 1/2 hour.
Some may also find it useful to read about a dozen questions on an important subject, thinking about how to set
up the solution to each one, but only working out in detail any questions they do not quickly see how to solve.
9
Material in italics is provided for those who want to know more about a particular subject and/or to be prepared for
more challenging exam questions; it could be directly needed to answer perhaps one question on an exam.
10
While this may indicate what ideas questions on your exam are likely to cover, every exam contains a few
questions on ideas that have yet to be asked. Your exam will have its own mix of questions.
hmahler@mac.com,
11
This is just an example of one possible schedule. Adjust it to suit your needs or make one up yourself.
hmahler@mac.com,
Past students helpful suggestions and questions have greatly improved this study guide.
I thank them! Feel free to send me any questions or suggestions:
Howard Mahler, Email: hmahler@mac.com
Please do not copy the Study Guide, except for your own personal use. Giving it to others is
unfair to yourself, your fellow students who have paid for them, and myself.12 If you found them
useful, tell a friend to buy his own.
Please send me any suspected errors by Email prior to the exam.
(Please specify as carefully as possible the page, Study Guide, and Exam.)
Author Biography:
Howard C. Mahler is a Fellow of the Casualty Actuarial Society,
and a Member of the American Academy of Actuaries.
He has taught actuarial exam seminars and published study guides since 1994.
He spent over 20 years in the insurance industry, the last 15 as Vice President and Actuary at the
Workers' Compensation Rating and Inspection Bureau of Massachusetts.
He has published many major research papers and won the 1987 CAS Dorweiler prize.
He served 12 years on the CAS Examination Committee including three years as head of the
whole committee (1990-1993).
Mr. Mahler has taught live seminars and/or classes for Exam C, Exam MFE,
CAS Exam ST, CAS Exam 5, and CAS Exam 8.
He has written study guides for all of the above.
hmahler@mac.com
12
www.howardmahler.com/Teaching
hmahler@mac.com,
Exam
Pass Mark
as % of
Available
Points
Number of
Candidates
Number
Passing
Number
Ineffective
Raw
Passing
Percent
MFE S07
MFE F07
MFE/3F S08
MFE/3F F08
N.A.
60%
55%
63%
1310
1944
2641
2768
601
994
1277
1215
165
152
240
299
45.9%
51.1%
48.4%
43.9%
52.5%
55.5%
53.2%
49.2%
MFE/3F S09
MFE/3F F09
MFE/3F S10
MFE/3F F10
60%
63%
59%
60%
3568
3217
3325
3232
1400
1116
1268
1140
320
371
320
342
39.2%
34.7%
38.1%
35.3%
43.1%
39.2%
42.2%
39.4%
MFE/3F S11
MFE/3F F11
71%14
72%
3404
3353
1515
1421
426
362
44.5%
42.4%
50.9%
47.5%
MFE/3F 4/12
MFE/3F 8/12
MFE/3F 11/12
76%
72%
72%
2834
2267
2393
1363
1094
1033
283
206
264
48.1%
48.3%
43.2%
53.4%
53.1%
48.5%
MFE/3F 3/13
MFE/3F 7/13
MFE/3F 11/13
72%
72%
72%
2676
2857
2303
1289
1414
972
226
282
246
48.2%
49.5%
42.2%
52.6%
54.9%
47.3%
MFE 3/14
MFE 7/14
MFE 11/14
72%
72%
72%
2550
2852
2885
1290
1298
1409
217
339
316
50.6%
45.5%
48.8%
55.3%
51.7%
54.2%
MFE 3/15
MFE 7/15
72%
72%
2486
2636
1241
1233
247
284
49.9%
46.8%
55.4%
52.4%
Effective
Passing
Percent
13
Information taken from the SOA webpage. Check the webpage for updated information.
Starting in May 2011, Exam 3F/MFE is administered using computer-based testing (CBT).
Under CBT, it is not possible to schedule everyone to take the examination at the same time. As a result, each
14
administration consists of multiple versions of the examination given over a period of several days. The
examinations are constructed and scored using Item Response Theory (IRT). Under IRT, each operational item
that appears on an examination has been calibrated for difficulty and other test statistics and the pass mark for each
examination is determined before the examination is given. All versions of the examination are constructed to be
of comparable difficulty to one another. For the May 2011 administration of Examination MFE/3F, an average of
71% correct was needed to pass the exam.
Mahlers Guide to
Financial Economics
Exam MFE
prepared by
Howard C. Mahler, FCAS
Copyright 2016 by Howard C. Mahler.
2016-MFE,
Financial Economics,
HCM 11/28/15,
Page 1
Pages
1
2
3
4
5
6
7
8
9
10
12-30
31-61
62-99
100-139
140-153
154-171
172-178
179-185
186-194
195-238
Introduction
European Options
Properties of Premiums of European Options
11
12
13
14
15
16
17
18
19
20
239-263
264-285
286-303
304-368
369-382
383-399
400-422
423-433
434-445
446-457
Replicating Portfolios
Risk Neutral Probabilities
Utility Theory and Risk Neutral Pricing
Binomial Trees, Risk Neutral Probabilities
Binomial Trees, Valuing Options on Other Assets
Other Binomial Trees
Binomial Trees, Actual Probabilities
Jensen's Inequality
Normal Distribution
LogNormal Distribution
Section Name
Put-Call Parity
Bounds on Premiums of European Options
Options on Currency
Exchange Options
Futures Contracts
Synthetic Positions
American Options
2016-MFE,
Section #
G
H
Financial Economics,
Pages
HCM 11/28/15,
Page 2
Section Name
21
22
23
24
25
26
27
28
29
30
458-462
463-516
517-565
566-575
576-582
583-591
592-616
617-637
638-649
650-671
31
32
33
34
35
36
37
38
39
40
672-714
715-725
726-742
743-767
768-781
782-787
788-793
794-802
803-804
805-850
Option Greeks
Delta-Gamma Approximation
Option Greeks in the Binomial Model
Profit on Options Prior to Expiration
Elasticity
Volatility of an Option
Risk Premium of an Option
Sharpe Ratio of an Option
Market Makers
Delta Hedging
41
42
43
44
45
46
47
48
49
50
851-868
869-870
871
872-896
897-935
936-982
983-1008
1009-1022
1023-1033
1034-1046
Gamma Hedging
Relationship to Insurance
Exotic Options
Asian Options
Barrier Options
Compound Options
Gap Options
Valuing European Exchange Options
Forward Start Options
Chooser Options
51
52
53
54
55
56
57
58
59
60
1047-1059
1060-1075
1076-1097
1098-1104
1105-1128
1129-1148
1149-1166
1167-1226
1227-1276
1277-1329
Black-Scholes Formula
Black-Scholes, Options on Currency
Black-Scholes, Options on Futures Contracts
Black-Scholes, Stocks Paying Discrete Dividends
Using Historical Data to Estimate Parameters of the Stock Price Model
Implied Volatility
Histograms
Normal Probability Plots
2016-MFE,
Section #
S
Financial Economics,
Pages
HCM 11/28/15,
Section Name
61
62
63
64
65
66
67
68
69
70
1330-1359
1360-1383
1384-1393
1394-1401
1402-1417
1418-1426
1427-1456
1457-1495
1496-1499
1500-1541
71
72
73
74
75
76
1542-1584
1585-1595
1596-1613
1614-1627
1628-1680
1681-1723
Page 3
2016-MFE,
Financial Economics,
HCM 11/28/15,
Page 4
Throughout I make many references to Derivatives Markets by McDonald; these are to the third
edition. One does not need the textbook in order to use my study guide; the references are to help
those who are also using the textbook.
Chapter of Third Edition Derivatives Markets
9
103
11.1 11.34
12.1-12.55
136
14
18
19.1-19.5
20.1-20.67
21.121.38
23.19
24.124.210
25.1-25.511
Appendix B.1
Appendix C
I have included in my early sections, the 9 questions from the 2007 FM Sample Exam for
Derivatives Markets, based on earlier chapters of the textbook.
Unless otherwise stated chapter appendices are not included in the required readings from this text.
2016-MFE,
Financial Economics,
HCM 11/28/15,
Page 5
For those who have the second edition of the textbook by McDonald:12
Chapter of Second Edition Derivatives Markets
9
1013
11.1 11.414
12.1-12.515
1316
14
18
19.1-19.5
20.1-20.717
21.121.318
22.119
23.123.220
24.1-24.521
Appendix B.1
Appendix C
I have included in my early sections, the 9 questions from the 2007 FM Sample Exam for
Derivatives Markets, based on earlier chapters of the textbook.
Unless otherwise stated chapter appendices are not included in the required readings from this text.
12
2016-MFE,
Financial Economics,
HCM 11/28/15,
Page 6
The market is frictionless. There are no taxes, transaction costs, bid/ask spreads, or restrictions
on short sales. All securities are perfectly divisible. Trading does not affect prices. Information
is available to all investors simultaneously. Every investor acts rationally
(i.e., there is no arbitrage.)
The MFE CBT exam will provide a formula document as well as a normal
distribution calculator that will be available during the test by clicking buttons on
the item screen. Details are available on the Prometric Web Site.
http://www.prometric.com/SOA/MFE3F_calculator.htm
Similar to other exam reference buttons, the normal distribution calculator button will be available
throughout the exam in the top right corner of every item screen. Click the button to call up the
calculator and calculate cumulative normal distribution and inverse cumulative normal distribution
values. Use these values to answer the question as needed.
When using the normal distribution calculator, values should be entered with five decimal places.
Use all five decimal places from the result in subsequent calculations.
The normal distribution calculator button replaces the Normal Table.
The previous rule on rounding no longer applies.24
You can try the normal distribution calculator button at the Prometric Web Site.
You will benefit from using it at least part of the time when you are studying.
The formula sheet contains the same information about the Normal and LogNormal distributions as
was provided in the past, as reproduced on the next page.
22
In 2007 the CAS and SOA gave separate exams. Starting in 2008 they gave a joint exam.
Starting in 2014 the SOA administers MFE alone.
23
The study note is available on the SOA webpage.
24
Unfortunately, most of my solutions were written up using the prior rule: On Joint Exam 3F/MFE, when using the
normal distribution, choose the nearest z-value to find the probability, or if the probability is given, choose the
nearest z-value. No interpolation should be used. For example, if the given z-value is 0.759, and you need to find
Pr(Z < 0.759) from the normal distribution table, then chose the probability for z-value = 0.76:
Pr(Z < 0.76) = 0.7764.
This should not make a significant difference.
2016-MFE,
Financial Economics,
HCM 11/28/15,
Page 7
2016-MFE,
Financial Economics,
HCM 11/28/15,
Page 8
2016-MFE,
Financial Economics,
Page 9
HCM 11/28/15,
B
B
1
2
3
4
5
6
7
8
9
C 10
C
11
12
13
14
D
E 15
16
17
18
F 19
E 20
21
22
23
G 24
25
H
26
27
28
29
30
Introduction
European Options
Properties of Premiums of Euro. Options
Put-Call Parity
MFE CAS 3
Sample 5/07
MFE
5/07
CAS 3
11/07
MFE/3F
5/09
25
2
1
3, 4
1, 4
14, 16
12
15
Black-Scholes Formula
Black-Scholes, Options on Currency
Black-Scholes, Options on Futures
Black-Scholes, Discrete Dividends
Historical Data to Estimate Parameters
Implied Volatility
Histograms
Normal Probability Plots
26
13
12
13
16
27
4, 49
17
18, 19, 23
14
15, 17
11
5, 46
14
2
50
6
7
55
20, 21
3, 8
20
21
15
17, 51
19
2016-MFE,
Financial Economics,
B
J
31
32
33
34
35
36
37
38
K 39
C 40
L
D
41
42
43
44
45
Option Greeks
Delta-Gamma Approximation
Option Greeks in the Binomial Model
Profit on Options Prior to Expiration
Elasticity
Volatility of an Option
Risk Premium of an Option
Sharpe Ratio of an Option
Market Makers
Delta Hedging
Gamma Hedging
Relationship to Insurance
Exotic Options
Asian Options
Barrier Options
MFE
Sample
CAS 3
5/07
MFE
5/07
CAS 3 MFE/3F
11/07
5/09
8, 31
17
20
19
44, 45, 69
40
20, 41
13
22
5
29
9, 47, 65
32
33
10
24
27
42
46
47
M 48
49
E
50
N 51
52
53
54
O 55
Compound Options
Gap Options
Valuing European Exchange Options
Forward Start Options
56
57
58
59
Ito Processes
60
Ito's Lemma
Chooser Options
Options on the Best of Two Assets
Cash-or-Nothing Options
Asset-or-Nothing Options
Random Walks
Standard Brownian Motion
Page 10
HCM 11/28/15,
34
18
17
28
26
19, 33
25
54
28, 53
6
4
34
16
35
18
10, 18
12
2016-MFE,
Financial Economics,
61
62
63
64
B
S 65
66
T 67
68
69
C 70
71
U 72
73
74
D
V 75
MFE
Sample
HCM 11/28/15,
CAS 3
5/07
MFE
5/07
Page 11
CAS 3 MFE/3F
11/07
5/09
11
8
52
36
13
15
21, 38, 60
7
3
15, 29, 30, 76
37
5
14
2016-MFE,
HCM 11/28/15,
Page 12
Section 1, Introduction
Earlier Chapters of Derivatives Markets by McDonald are on Exam 2/FM.29
Some of the ideas covered in those chapters are used in the chapters on your exam.
Derivatives:30
A derivative is an agreement between two people that has a value determined by the price of
something else.
For example, Alan gives Bob the right to buy from Alan a share of IBM stock one year from now at
a price of $120. This is an example of a stock option. The value of this option depends on the price
of IBM stock one year from now.
Options:
A call is an option to buy. For example, Bob purchased a call option on IBM stock from Alan.
A put is an option to sell.
For example, if Debra purchased a put option on IBM stock from Carol, then Debra will have the
option in the future to sell a share of IBM stock to Carol at a specified price.
Continuously Compounded Risk Free Rate:31
If r is the continuously compounded annual risk free rate, then the present value of $1 T years in the
future is: e-rT.
r as used by McDonald is what an actuary would call the force of interest.
Effective Annual Rate:32
If r is the effective annual risk free rate, then the present value of $1 T years in the future is: 1/(1+r)T.
An effective annual rate is what an actuary would call the rate of interest.
Effective annual rate will be used in Interest Rate Caps and the Black-Derman-Toy Model, to be
discussed in subsequent sections. Otherwise, we will use continuously compounded rates.
29
3rd edition, Chapters 13, Chapter 4 (4.14.4), Chapter 5 (5.15.4 and Appendix 5.B),
Chapter 8 (8.18.3).
30
Warren E. Buffett has said, Derivatives are financial weapons of mass destruction, carrying dangers that, while
now latent, are potentially lethal.
31
See Appendix B.1 of Derivatives Markets by McDonald.
32
See Appendix B.1 of Derivatives Markets by McDonald.
2016-MFE,
HCM 11/28/15,
Page 13
Selling Short:
If we sell a stock short, then we borrow a share of stock and sell it for the current market price. We will
give this person a share of stock at the designated time in the future. We also must pay this person
any stock dividends they would have gotten on the stock, when they would have gotten them.
Forward Contracts:
A forward contract is an agreement that sets the terms today, but the buying or selling
of the asset takes place in the future.
For example, Ed will be moving in a month, and his friend Fred agrees to buy Eds TV one month
from now for $200.
The purchaser of an option has bought the right to do something in the future, but has no obligation
to do anything. In contrast, in a forward contract both parties are obligated to fulfill their parts of the
contract.
Value of a Forward Contract:
F0,T = forward price at time T in the future.
For example, if Joe buys a forward contract to buy one share of ABC stock in two years at $120,
then F0,2 = $120. At time 2 years, Joe pays $120 and gets one share of stock.33
PV[F0,T] is the present value at time 0 of a forward contract to be executed at time T.
PV[F0,T] = F0,T e-rT.
Let us assume the current price of XYZ stock is S0 .
Assume XYZ stock pays no dividends.
Charlie can buy a forward contract to buy one share of XYZ stock in exchange for paying F0,T at
time T. If Charlie invests F0,T e-rT at the risk free rate, then at time T he will have F0,T.34
He uses that amount to fulfill his forward contract and at time T Charlie has one share of XYZ Stock.
Lucy can instead buy one share of XYZ stock now, for the current market price of S0 , and hold onto
the share of stock until at least time T.
33
This differs from the prepaid price. Joe might instead be able to pay $110 now and get a share of stock 2 years
from now. This is an example of a prepaid futures contract.
34
Charlie could invest in a Treasury Bond.
2016-MFE,
HCM 11/28/15,
Page 14
Both Lucy and Charlie end up in the same situation, with one share of XYZ stock at time T.
Therefore, their investments must have equal present value.
S 0 = F0,T e-rT.
F0,T = S0 erT, in the absence of dividends.
If instead XYZ stock pays dividends, then Lucy would have collected any dividends paid from time
0 to T, while she owned the stock. Charlie would not. Thus Lucys position is equal to Charlies
position plus a receipt of dividends.
Therefore, S0 - PV[Div] = F0,T e-rT.
F0 , T = S0 er T - PV[Div] er T.
If the dividends are paid at discrete points in time, with amount Dti paid at time ti, then
F0 , T = S0 er T -
er(T -
ti)
Dt i .
35
2016-MFE,
HCM 11/28/15,
Page 15
Type of Market
Liquidity
Contract Form
Performance Guarantee
Transaction Costs
Forward Contract
Dealer or Broker
Low
Customized
Creditworthiness
Bid-ask spread
Futures Contract
(Commodities) Exchange
High
Standard
Mark-to-Market
Fees or Commissions
Continuous Dividends:
We often assume that dividends are paid at a continuous rate .38 Over a short period of time dt,
stock dividends of: S(t) dt are paid, where S(t) is the stock price at time t.
So that if one buy a share of stock at time 0, and reinvests the dividends in the stock, at time T one
would have eT shares of the stock.39
Exercise: One buys 1 million shares of a stock that pays dividends at the continuous annual rate of
2%. The dividends are reinvested in that stock.
After 3 years how many shares of the stock does one own?
[Solution: (1 million)e(3)(0.02) = 1,061,837 shares.]
If XYZ stock pays continuous dividends at a rate , and Lucy buys e-T shares of XYZ stock now,
then Lucy would have one share of the stock at time T. Charlie buys a future contract for one share of
the stock. If Charlie invests F0,T e-rT at the risk free rate, then at time T he will have F0,T.40 At time T
Charlies position equals Lucys; they both own a share of stock. Therefore, F0,T e-rT = S0 e-T.
Therefore, in the case of dividends paid continuously: F0 , T = S0 eT(r - ) .
Prepaid Forward Price:
The forward price is the price we would pay in the future for a forward contract. In contrast, the
P , is the price we would pay today for a forward contract.
prepaid forward price, F0,T
P =F
F0,T
0 , T e-rT.
37
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For example, let us assume we are paying today in order to own a share stock at time 3. Then the
P
prepaid forward price is F0,3
(S).
We would pay this price at time 0 in exchange for receiving the stock at time 3.
However, we would not receive any dividends the stock would pay between time 0 and 3.
P (S) = S - PV[Div].
Therefore, in the case of discrete dividends, F0,T
0
Exercise: The current price of a stock is 120. The stock will pay a dividend of 3 in 2 months.
What is the 5 month prepaid forward price of the stock? r = 6%.
[Solution: S0 - PV[Div] = 120 - 3e-(2/12)(6%) = 117.03.]
P (S) = S e-T .
In the case of continuous dividends, F0,T
0
Exercise: The current price of a stock is 80. The stock pays dividends at a continuous rate of 1%.
What is the 5 month prepaid forward price of the stock?
[Solution: S0 e-T = 80e-(5/12)(1%) = 79.67.]
If we pay S0 e-T in order to buy e-T shares of stock today and reinvest the dividends we would
have one share of stock at time T. Thus S0 e-T is the price we would pay today to own one share
of stock at time T. More generally, FtP, T (S) = St e-(T-t).
Continuously Compounded Returns:
Let St and St+h be the stock prices at times t and t+h. Then the continuously compounded return on
the stock between time t and t+h is: ln[St+h / St]. On an annual basis, this return is: ln[St+h / St] / h.
For example, if the stock price is $80 at time 0 and $90 at time 2 years, then the continuously
compounded return from time 0 to 2 is: ln[90/80] = 11.78%. On an annual basis, this return is:
11.78% / 2 = 5.89%.
Exercise: The stock price is $90 at time 2 years and $85 at time 2.5 years, what is the annual
continuously compounded return?
[Solution: ln[85/90] / 0.5 = -11.4%.]
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One can get the future stock price from the current stock price and the continuously compounded
return. For example, if the current stock price is $100, and the continuously compounded return over
the next three years is 8% per year, then the stock three years from now is: 100 e0.24 = $127.12.
Exercise: The current price of a stock price is $60. Over the next four years the annual continuously
compounded return are: 17%, 33%, -140%, and 6%. What is the stock price in four years?
[Solution: 60 exp[0.17] exp[0.33] exp[-1.40] exp[0.06] = 60 exp[-0.84] = $25.90.
Comment: The continuously compounded returns add; the return over the whole four years is:
17% + 33% - 140% + 6% = -84%.
When the stock price declines by a very large amount, one can have a continuously compounded
return of less than -100%.]
Volatility:
The volatility of a stock is the standard deviation of its continuously compounded returns.41
Actuarial Present Values:42
Let us assume that one year from now an insurer will pay either $50 with probability 70% or $100
with probability 30%. Then the expected payment in one year is: (0.7)(50) + (0.3)(100) = $65.
Assume that the continuously compound annual rate of interest is now 5%.
Then the actuarial present value of the insurers payment is: 65 e-0.05 = $61.83.43
In general in order to calculate an actuarial present value, one takes a sum of the expected
payments at each point in time each multiplied by the appropriate discount factor. The discount
factor adjusts for the difference between the time value of money at the present and at the time
when the payment is made.
Exercise: In addition to the payments one year from now, the insurer will pay two years from now
either $50 with probability 50%, $100 with probability 40%, or $200 with probability 10%.
Assume that one year from now the continuously compound annual rate of interest will be 6%.
Determine the actuarial present value of the insurers total payments, including those made one year
from now and two years from now.
[Solution: The expected payment in two years is: (0.5)(50) + (0.4)(100) + (0.1)(200) = $85.
Discounting back to the present: 85 exp[-0.05 - 0.06] = $76.15.
Adding in the actuarial present value of the payments made in one year, the actuarial present value
of the insurers total payments is: $61.83 + $76.15 = $137.98.]
41
Volatility will be discussed in subsequent sections and is usually stated on an annual basis.
Covered extensively on CAS Exam LC and SOA Exam MLC.
43
If instead the 5% were an effective annual rate, then the actuarial present value would be: 65/1.05 = $61.90.
42
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Named Positions:44
One can buy various combinations of options and stock.
The more common such positions have been given names.
Bear Spread: The sale of an option together with the purchase of an otherwise identical
option with a higher strike price. Can construct a bear spread using either puts or calls.
The owner of the Bear Spread hopes that the stock price moves down.
Box Spread: Buy a call and sell a put at one strike price, plus at another (higher) strike
price sell a call and buy a put.45
Bull Spread: The purchase of an option together with the sale of an otherwise identical
option with a higher strike price. Can construct a bull spread using either puts or calls.
The owner of the Bull Spread hopes that the stock price moves up.
Butterfly Spread: Buying a K strike option, selling two K + K strike options,
and buying a K + 2K strike option.
Collar: Purchase a put and sell a call with a higher strike price.
Ratio Spread: Buying m of an option and selling n of an otherwise identical option at a
different strike.
Straddle: Purchase a call and the otherwise identical put.
Strangle: The purchase of a put and a higher strike call with the same time until
expiration.
44
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For example, Vanessa buys a 90 strike call and sells an otherwise identical 100 strike call.
This is an example of a Call Bull Spread. Vanessa hopes the stock price increases.
If Vanessa bought her 90 strike call from Nathan and sold her 100 strike call to Nathan, than Nathan
owns a Call Bear Spread. Nathan hopes the stock price declines.
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Problems:
1.1 (1 point) A stock price is 160. Assume r = 0.08 and there are no dividends.
What is the 4-year forward price?
A. less than 200
B. at least 200 but less than 210
C. at least 210 but less than 220
D. at least 220 but less than 230
E. at least 230
1.2 (1 point) A stock has a current price of 120.
The stock pays dividends at a continuously compounded rate of 1.5%. r = 0.08.
What is the 4-year prepaid forward price?
A. 113
B. 115
C. 117
D. 119
E. 121
1.3 (1 point) A stock has a two-year forward price of 99.66.
The stock pays dividends at a continuously compounded rate of 3%. r = 7%.
What is the current price of this stock?
A. 90
B. 92
C. 94
D. 96
E. 98
1.4 (1 point) A stock has a current price of 90.
The stock pays dividends at a continuously compounded rate of 2%. r = 0.06.
What is the 5-year forward price?
A. 100
B. 105
C. 110
D. 115
E. 120
1.5 (1 point) A stock has a current price of $100.
In 3 months the stock will pay a dividend of $2. r = 0.04.
What is the 4-month prepaid forward price?
1.6 (1 point) A stock has a four-year forward price of 89.43.
The stock pays dividends at a continuously compounded rate of 0.8%. r = 5.2%.
What is the current price of this stock?
A. 65
B. 70
C. 75
D. 80
E. 85
1.7 (1 point) Options are extremely risky investments.
The variance of returns is great, yet most people are assumed to be risk-averse.
Moreover, brokerage commissions on options are high.
So why are options and other derivative securities such popular financial instruments?
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1.13 (FM Sample Exam, Q.4) Zero-coupon risk-free bonds are available with the following
maturities and yield rates (effective, annual):
Maturity (years)
Yield
1
0.06
2
0.065
3
0.07
You need to buy corn for producing ethanol. You want to purchase 10,000 bushels one year from
now, 15,000 bushels two years from now, and 20,000 bushels three years from now. The current
forward prices, per bushel, are 3.89, 4.11, and 4.16 for one, two, and three years respectively.
You want to enter into a commodity swap to lock in these prices.
Which of the following sequences of payments at times one, two, and three will NOT be acceptable
to you and to the corn supplier?
A. 38,900, 61,650, 83,200
B. 39,083, 61,650, 82,039
C. 40,777, 61,166, 81,554
D. 41,892, 62,340, 78,997
E. 60,184, 60,184, 60,184
1.14 (FM Sample Exam, Q.6) The current price of one share of XYZ stock is 100. The forward
price for delivery of one share of XYZ stock in one year is 105. Which of the following statements
about the expected price of one share of XYZ stock in one year is TRUE?
A. It will be less than 100
B. It will be equal to 100
C. It will be strictly between 100 and 105
D. It will be equal to 105
E. It will be greater than 105.
1.15 (FM Sample Exam, Q.7) A non-dividend paying stock currently sells for 100.
One year from now the stock sells for 110.
The risk-free rate, compounded continuously, is 6%.
The stock is purchased in the following manner:
You pay 100 today
You take possession of the security in one year
Which of the following describes this arrangement?
A. Outright purchase
B. Fully leveraged purchase
C. Prepaid forward contract
D. Forward contract
E. This arrangement is not possible due to arbitrage opportunities
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1.16 (FM Sample Exam, Q.8) You believe that the volatility of a stock is higher than indicated by
market prices for options on that stock. You want to speculate on that belief by buying or selling
at-the-money options. What should you do?
A. Buy a strangle
B. Buy a straddle
C. Sell a straddle
D. Buy a butterfly spread
E. Sell a butterfly spread
1.17 (CAS3, 11/07, Q.25) (2.5 points) On January 1, 2007, the Florida Property Company
purchases a one-year property insurance policy with a deductible of $50,000. In the event of a
hurricane, the insurance company will pay the Florida Property Company for losses in excess of the
deductible. Payment occurs on December 31, 2007. For the last three months of 2007, there is a
20% chance that a single hurricane occurs and an 80% chance that no hurricane occurs. If a hurricane
occurs, then the Florida Property Company will experience $1,000,000 in losses. The continuously
compounded risk-free rate is 5%. On October 1, 2007, what is the risk-neutral expected value of
the insurance policy to the Florida Property Company?
A. Less than $185,000
B. At least $185,000, but less than $190,000
C. At least $190,000, but less than $195,000
D. At least $195,000, but less than $200,000
E. At least $200,000
1.18 (IOA CT8, 9/08, Q.6) (6 points) Consider an asset S paying a dividend at a constant
instantaneous rate of , a forward contract with maturity T written on S and a constant, instantaneous
(continuously compounded) risk-free rate of r.
Derive the price at time t of the forward contract, using the no-arbitrage principle.
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1.19 (CAS8, 5/09, Q.21) (2.25 points) Given the following information about a box spread
related to 1,000 shares of Company XYZ stock:
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Solutions to Problems:
1.1. D. (160)exp[(0.08)(4)] = $220.34.
P (S) = S e-T = (120) exp[-(1.5%)(4)] = 113.01.
1.2. A. F0,T
0
Comment: This prepaid forward price, is what we pay today for delivery of the stock 4 years from
now. We do not receive any of the dividend payments during those 4 years.
1.3. B. The prepaid forward price is the forward price discounted for interest: 99.66 / e0.14 = 86.64.
(current price) e-T = (current price) e-0.06 = prepaid forward price = 86.64.
Comment: This prepaid forward price, is what we pay today for delivery of the stock 4 months from
now. We do not receive the dividend payment 3 months from now.
1.6. C. Forward price = S0 exp[(r-)T]. 89.43 = S0 exp[(5.2% - 0.8%)(4)]. S0 = 75.00.
Alternately, the prepaid forward price is the forward price discounted for interest:
89.43 / e0.208 = 72.64.
(current price) e-T = (current price) e-0.032 = prepaid forward price = 72.64.
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1.8. a. 1. Futures and forward contracts are obligations to buy or sell commodities or
securities in the future at prices determined now. Futures are standardized contracts traded on
exchanges. Forward contracts are individualized tailor-made contracts that are not traded on
exchanges.
2. Options give the purchaser the right to buy (call option) or sell (put option) securities at fixed
prices in the future.
3. Swaps are obligations to exchange commodities or values at a number of points in the future.
For instance, currency swaps exchange interest payments in different currencies.
Interest rate swaps may exchange a fixed coupon payment for a variable coupon payment.
b. Firms use these instruments to hedge uncertainties in securities prices (e.g., by call and put
options), commodities prices (e.g., by futures contracts), in currency rates (e.g., by currency swaps),
and in interest rates (e.g., by interest rate swaps).
1.9. D. In the case of futures contract, we pay upon delivery; we do not pay cash in advance.
1.10. A. Statement #1 is true.
A futures contract is traded on an organized exchange. Thus Statement #2 is false.
Statement #3 describes convertible bonds, and thus is false. Swaps are of various types,
generally involving the exchange of interest received on fixed-income securities, such as
exchanging bond interest paid in U.S. dollars for interest in Euros, or exchanging interest paid at a
fixed rate for interest paid at a variable rate.
1.11. a. A warrant is a security that entitles the holder to buy the underlying stock of the issuing
company at a fixed strike price until the expiry date. A warrant is similar to an American call option,
but it is issued by a firm on its own stock; if the warrant is exercised, new shares of stock are issued.
Convertible bond is like conventional debt, but it gives the holder the right to exchange the bond for
a fixed number of newly issued shares in the firm.
b. If the stock price on the expiration date is significantly higher than the price on the issuance date,
then the warrant holder will exercise and the convertible bond holder will convert.
c. If stock the price on the expiration date is significantly lower than the price on the issuance date, the
warrant holder will not exercise and the convertible bond holder will not convert.
1.12. B. A warrant is an option issued by a firm with its own stock as the underlying asset.
A futures contract is traded on an organized exchange.
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1.14. E. The forward price is a biased downwards predictor of the future price.
Therefore, the expected future price of XYZ stock is greater than its forward price of 105.
Comment: Someone who bought the stock should be compensated for time and risk.
The one year forward price is S0 er > S0 , where r is the continuously compounded annual risk free
rate. If this were the expected future stock price, then someone who bought the stock would only be
compensated for time. In order to also be compensated for risk, the expected future stock price
must be greater than the forward price.
1.15. C. All four of answers A-D are methods of acquiring the stock.
Of these, the prepaid forward has the payment at time 0 and the delivery at time T.
Comment: See Table 5.1 in Derivatives Markets by McDonald.
Since there are no dividends, the prepaid forward price is equal to the current price of 100.
In a fully leveraged purchase, you get the stock today and pay 100e0.06 one year from now. In a
forward contract, you get the stock one year from now and pay the forward price, which since there
are no dividends is 100e0.06. In an outright purchase you would pay 100 today and also get the
stock today.
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1.19. (a) Box Spread: Buy a call and sell a put at one strike price, plus at another (higher) strike
price sell a call and buy a put. For European options, the box spread is equivalent to a zero-coupon
bond.
Here the owner of the box spread, would buy a $110 strike call, sell a $110 strike put, sell a $120
strike call, and buy a 120 strike put.
The payoff on this box spread is: (ST - 110)+ - (110 - ST)+ - (ST - 120)+ + (120 - ST)+.
If ST < 110, then the payoff is: 0 - (110 - ST) + (120 - ST) = 10.
If 120 > ST > 110, then the payoff is: (ST - 110) + (120 - ST) = 10.
If ST > 120, then the payoff is: (ST - 110) - (ST - 120) = 10.
The payoff is always 10; there is no stock price risk.
Thus the appropriate premium for one box spread is: 10 exp[-0.05] = 9.512.
Therefore, for 1000 box spreads, the appropriate premium is $9512.
At $9,750, the box spread is overpriced.
I would sell the box spread to investor A,
earning a profit now of: 9,750 - 9512 = $238.
Alternately, I sell the box spread to investor A and invest the money at the risk free rate of 5%
for one year, and have: (9750)(e0.05) = 10,250. I then pay investor A (1000)(10) = $10,000.
I make a profit of 10,250 - $10,000 = $250 in one year.
(b) Investor A owns a $120 strike put as part of the box spread.
Since Investor A believes that the price of the stock will not decrease, he expects this put to have a
payoff of $120 - $100 = $20 or less.
Therefore, Investor A will want to lock in his $20 payoff, and Investor A should exercise this
$120 strike American put right away.
When he does so, I would have to pay him: (1000)($120) = $120,000, for shares of stock that are
only worth: (1000)($100) = $100,000. (Investor A will hold onto his $110 strike call, and hope it will
be in the money sometime during the year.)
(You can also exercise the options you own, such as the $110 strike put, but the question does not
ask about that. As will be discussed, in general, it can be hard to decide whether it is optimal to
exercise an American option early.)
Comment: Investor A owns a $120 strike put and a $110 strike call, which you are responsible for
fulfilling if he exercise them. You own a $110 strike put and a $120 strike call, which Investor A is
responsible for fulfilling if you exercise them.
If all of the options are European, then at expiration in one year, regardless of the stock price, you will
get a net payoff from all four of the options of -$10, while Investor A gets a net payoff of $10.
In part (b), when all of the options are American, they may be exercised at different times. Now the
net payoff is uncertain and depends on when each of the options is exercised and the stock prices at
those times. The net payoff to Investor A from all four options will depend on both his and your
decisions as well as the stock price path over the next year.
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1.20. a. The investor will get 1,000,000 Euros two years from now if he now buys
Euro-denominated bonds in an amount of: 1 million / exp[(2)(2%)] = 960,789.
In order to buy these bonds requires: ($1.50)(960,789) = $1,441,184.
Thus the investor borrows $1,441,184 at the U.S. risk-free rate,
and lends 960,789 Euros at the Euro risk-free rate.
At the end of 2 years, the investor receives 1,000,000 Euros and must pay back:
exp[(2)(1%)] $1,441,184 = $1,470,298.
b. In part a we saw that the investor can borrow $1,441,184 to set up a position that gives the
same cashflows as the forward contract; this involves paying back $1,470,298 two years from now.
Thus the forward price of $1,475,000 is too high.
The investor can sell the forward contract (take a short position), lend 960,789 Euros, and borrow
$1,441,184. (By selling the forward contract he has agreed to deliver Euros.
He has bought a synthetic forward contract as well as sold an actual forward contract.)
In two years the investor has 1,000,000 Euros, which he delivers to satisfy the forward contract.
He receives $1,475,000 from fulfilling the forward contract.
After paying back the $1,470,298 he has a net of: $1,475,000 - $1,470,298 = $4702.
The present value of this arbitrage profit is: $4702 / exp[(2)(1%)] = $4609.
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While for simplicity I have used in the example one share, one could buy an option for 100 shares or 1000 shares.
There are other exercise styles. See page 32 of Derivatives Markets by McDonald.
Others will be discussed subsequently.
49
And ignoring any transaction costs.
50
Dick has not agreed to buy a share from Jane. Dick does not have an obligation to buy, rather Dick has purchased
the right to buy a share if he wishes to.
48
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When the stock price is greater than the strike price, exercising the option makes money; this call
option is in the money. If the stock price and strike price are equal, then the option is at the
money. If the stock price is less than the strike price, then the call option is out of the money.
Y if Y 0 51
Let Y+ = Max[0, Y] =
.
0 if Y < 0
Then the eventual payoff on Dicks call option is (S1 - 150)+, where S1 is the price of ABC Stock
one year from now. Here is a graph of the future value of Dicks call option:
Call Payoff
140
120
100
80
60
40
20
50
100
150
200
250
300
Stock Price
In general, the future value of a European call option is: (ST - K)+, where ST is the price of the
stock on the expiration date of the call and K is the strike price of the call.
Put Options:
XYZ Stock is currently selling for $200. Mary buys from Rob an option to sell one year from today
a share of XYZ Stock for $250. If one year from now XYZ Stock has a market price of less than
$250, then Mary should buy a share of XYZ Stock at the market price and then use her option to
sell a share of XYZ Stock to Rob for $250, making a profit.
This is an example of a European Put Option.
A European Put Option gives the buyer the right to sell one share of a certain stock at a
strike price (exercise price) upon expiration. A put is an option to sell.
Mary has purchased a 1 year European Put Option on XYZ Stock, with a strike price of $250.
51
This very useful actuarial notation is not on the syllabus of this exam.
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The eventual value of Marys put option is (250 - S1 )+, where S1 is the price of XYZ Stock one
year from now.54 Here is a graph of the future value of Marys put option:
Put Payoff
250
200
150
100
50
100
200
300
400
500
Stock Price
In general, the future value of a European put option is: (K - ST ) +, where ST is the price of the
stock on the expiration date and K is the strike price.
52
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When the stock price is less than the strike price, exercising the put makes money; this put option is
in the money. If the stock price and strike price are equal, then the option is at the money.
If the stock price is greater than the strike price, then the put option is out of the money.
Expected Future Value of an Option:
The future payoff on a European call option is: (ST - K)+, where ST is the price of the stock on the
expiration date and K is the strike price. The future payoff on a European put option is: (K - ST)+.
Of course, at the time one could purchase an option, one does not know the future price of the stock.
The future price of the stock is a random variable. The expected value of the option can be obtained
by averaging using the distribution of future stock prices.
The expected future value of a European call option is: E[(ST - K)+].
The expected future value of a European put option is: E[(K - ST)+].
If one knew the distribution of ST, then
E[(ST - K)+] = E[ST - K | ST > K] Prob[ST > K] + (0)Prob[ST K]
= (E[ST | ST > K] - K) Prob[ ST > K].
Similarly,
E[(K - ST)+] = (0)Prob[ST > K] + E[K - ST | ST K] Prob[ ST K]
= (K- E[ST | St K]) Prob[ ST K].
Limited Expected Values:55
Let X K = Min[X, K].
Then the limited expected value is: E[X
E[(ST - K)+] = E[ST] - E[ST
E[(K - ST)+] = K - E[ST
K].
K].
K].
This manner of writing the expected future value can be useful if for example the distribution of future
prices is LogNormal and if one had a formula for the limited expected value of a LogNormal
Distribution.56
55
56
See Mahlers Guide to Loss Distributions or Loss Models, covering material on the syllabus of Exam C.
If the distribution of St were LogNormal, this would lead to the Black-Scholes formula for valuing a put option.
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Problems:
Use the following information for the next 3 questions:
The price of the stock of the Daily Planet Media Company 1 year from now has the following
distribution:
Price Probability
60 20%
80 30%
100 30%
120 20%
2.1 (1 point) Determine the expected stock price of Daily Planet Media Company one year from
now.
2.2 (1 point) Determine the expected payoff of a 1 year European call option on one share of Daily
Planet Media Company, with a strike price of 85.
(A) Less than 7
(B) At least 7, but less than 9
(C) At least 9, but less than 11
(D) At least 11, but less than 13
(E) At least 13
2.3 (1 point) Determine the expected payoff of a 1 year European put option on one share of Daily
Planet Media Company, with a strike price of 85.
A) Less than 7
(B) At least 7, but less than 9
(C) At least 9, but less than 11
(D) At least 11, but less than 13
(E) At least 13
2.4 (2 points) Graph the future value of a European call option with a strike price of 100, as a function
of the future stock price.
2.5 (2 points) Graph the future value of a European put option with a strike price of 100, as a
function of the future stock price.
2.6 (2 points) Graph the payoff on a European call option with a strike price of 100 plus the
corresponding put, as a function of the future stock price. This position is called a straddle.
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2.7 (3 points) Christopher buys a $60 strike European call, sells two $70 strike European calls,
and buys an $80 strike European call.
The options are on the same stock and have the same expiration date.
This position is called a Butterfly Spread.
Graph the payoff on this portfolio as a function of the future price of the stock.
2.8 (2 points) Jason buys a $100 strike European put, and sells a $120 strike European put.
The puts are on the same stock and have the same expiration date.
This position is called a Put Bull Spread.
Graph the payoff on this portfolio as a function of the future price of the stock.
2.9 (3 points) Melissa buys a $90 strike European call, sells a $90 strike European put,
sells a $130 strike European call, and buys a $130 strike European put.
The options are on the same stock and have the same expiration date.
This position is called a Box Spread.
Graph the payoff on this portfolio as a function of the future price of the stock.
2.10 (3 points) Amanda buys two $100 strike European call, sells three $110 strike European calls,
and buys a $130 strike European call.
The options are on the same stock and have the same expiration date.
This position is called a Asymmetric Butterfly Spread.
Graph the payoff on this portfolio as a function of the future price of the stock.
2.11 (3 points) Robert buys 1000 calls on a stock with a strike price of $120.
The premium per call is $8. Robert also pays a total commission of $100.
Determine the stock price at expiration at which Robert will break even.
Graph Roberts profit as a percent of his initial investment, as a function of the stock price at
expiration of the call. (Ignore the time value of money.)
2.12 (2 points) Tiffany buys a $90 strike European call and sells a $90 strike European put.
The options are on the same stock and have the same expiration date.
Graph the payoff on this portfolio as a function of the future price of the stock.
2.13 (3 points) Heather buys a $70 strike European put and sells a $90 strike European call.
The options are on the same stock and have the same expiration date.
This position is called a Collar.
Graph the payoff on this portfolio as a function of the future price of the stock.
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2.21 (1 point) Several years ago Warren bought 1000 shares of XYZ stock.
Fortunately for Warren the value of XYZ stock has increased substantially since then.
However, for tax reasons Warren does not wish to sell his XYZ stock and realize his capital gains.
Rather Warren plans to sell his XYZ stock one year from now.
Warren is worried that by time he is ready to sell his stock his capital gains may decrease or vanish.
Briefly describe how Warren could purchase a European option to hedge this risk.
2.22 (2 points) Lauren buys a 70 strike put and a 90 strike call. The options have the same
expiration date. Graph the value of this portfolio when the options expire as a function of the future
price of the stock. This position is called a strangle.
2.23 (1 point)
You buy a European call with a strike price of 80 and sell a European put with a strike price of 80.
You also sell a European call with a strike price of 100 and buy a European put with a strike price of
100. All of these options are on the same stock and have the same expiration date.
Which of the following is a graph of the payoff on this portfolio as a function of the future price of the
stock?
Payoff
20
Payoff
40
A.
30
10
50
100
150
S
200
- 10
20
10
- 20
50
Payoff
Payoff
C.
75
50
25
- 25
- 50
- 75
- 100
B.
100
150
S
200
D.
100
50
50
100
E. None of A, B, C, or D.
150
S
200
50
- 50
- 100
100
150
S
200
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2.24 (1 point) The Rich and Fine Stock Index has a current price of 800.
An insurer offers a contract that will pay the value of the Rich and Fine Stock Index two years from
now; however, the contract will pay a minimum of 750. The insurer buys the index.
Briefly describe how the insurer could purchase a European option to hedge its risk.
2.25 (2 points) Options traders often refer to straddles and butterflies. Here is an example of each.
Straddle: Buy a call with strike price of $100 and simultaneously buy a put with strike price of $100.
Butterfly spread: Simultaneously buy one call with strike price of $100, sell two calls with strike price
of $110, and buy one call with strike price of $120.
Draw position diagrams for the straddle and butterfly, showing the payoffs from the investor's net
position. Each strategy is a bet on variability. Explain briefly the nature of each bet.
2.26 (1 point) You sell a European call with a strike price of 110,
and buy a European put with a strike price of 90.
The put and call are on the same stock and have the same expiration date.
Which of the following is a graph of the payoff on this portfolio as a function of the future price of the
stock?
Payoff
40
Payoff
40
A.
30
20
60
80
100
120
140
20
10
- 20
- 40
60
Payoff
60
80
Payoff
40
C.
40
D.
20
20
- 20
B.
60
80
100
- 40
- 60
E. None of A, B, C, or D
120
140
60
- 20
- 40
80
100
120
140
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2.31 (CAS5B, 5/95, Q.13) (1 point) You own a share of XYZ stock and are concerned that the
price of the stock may fall. Of the following choices, which would allow you to offset (at least partially)
potential future losses?
1. Buy a put on the share of stock.
2. Sell the stock short.
3. Sell a call on the share of stock.
A. 1
B. 2
C. 1, 2
D. 1, 2, 3
E. None of 1, 2, 3
2.32 (CAS5B, 5/95, Q.32) (2 points) The RegLuar Firm, Inc., a publicly held corporation, having
current assets of $75 million and no liabilities, borrows $50 million by issuing a zero coupon bond
due in two years. Assume no other transactions occur after the bond is issued and before it is
redeemed.
a. (1/2 point) Briefly describe this transaction in terms of options.
b. (3/4 points) If the value of the company's assets falls to $40 million at the end of one year,
discuss whether the stock has a nonzero value.
c. (3/4 points) At the end of two years, if the value of the company's assets falls to $40 million just
before the debt is paid, discuss whether the stock has nonzero value.
2.33 (CAS5B, 5/95, Q.35) (1.5 points)
a. (1 point) Explain how a term life insurance policy on the life of an actively employed actuary can
function similarly to a put option owned by the actuary's dependents.
b. (1/2 point) Under what circumstances does the term life policy fall short of operating like a put?
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2.34 (CAS5B, 11/98, Q.15) (1 point) What combination of stocks, options and borrowing/lending
could be represented by the following position diagram?
Valueof Position
50
100
150
200
Share Price
- 20
- 40
- 60
- 80
- 100
1. Sell one share of stock short and borrow the present value of $100.
2. Sell one call with strike price of $100 and sell one put with strike price of $100.
3. Sell one share of stock short, sell two puts with strike price of $100, and lend the present
value of $100.
A. 1
B. 2
C. 3
D. 2, 3
E. 1, 2, 3
2.35 (CAS5B, 11/99, Q.30) (2 points) ABC Insurance Company has purchased a reinsurance
contract from Reliable Reinsurer providing coverage for $10 million in excess of $20 million. In other
words, Reliable Reinsurer has agreed to pay up to, but no more than, $10 million beyond the initial
$20 million in loss dollars retained by ABC.
a. (1 point) Draw a position diagram showing the payoff to ABC from the reinsurance as a function of
the amount of ABC's total loss. Label both axes.
b. (1 point) If we think of ABC's total loss as the "underlying asset," we can model this reinsurance
contract as a mixture of simple options.
Describe the option position that replicates the payoffs from the reinsurance contract.
2.36 (CAS5B, 11/99, Q.31) (2 points) Norbert Corporation owns a vacant lot with a book value
of $50,000. By a stroke of luck, Norbert finds a buyer willing to pay $200,000 for the lot. However,
Norbert must also give the buyer a put option to sell the lot back to Norbert for $200,000 at the end
of two years. Moreover, Norbert agrees to pay the buyer $40,000 for a call option to repurchase
the lot for $200,000 at the end of two years.
a. (1 point) What would likely happen if the lot is worth more than $200,000 at the end of
two years? What if it is worth less than $200,000? Why?
b. (1 point) In effect, Norbert has borrowed money from the buyer.
What is the effective annual interest rate per year on the loan? Show all work.
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2.37 (FM Sample Exam, Q.3) Happy Jalapenos, LLC has an exclusive contract to supply
jalapeno peppers to the organizers of the annual jalapeno eating contest. The contract states that
the contest organizers will take delivery of 10,000 jalapenos in one year at the market price. It will
cost Happy Jalapenos 1,000 to provide 10,000 jalapenos and todays market price is 0.12 for one
jalapeno. The continuously compounded risk-free interest rate is 6%.
Happy Jalapenos has decided to hedge as follows (both options are one-year, European):
Buy 10,000 0.12-strike put options for 84.30 and sell 10,000 0.14-strike call options for 74.80.
Happy Jalapenos believes the market price in one year will be somewhere between 0.10 and
0.15 per pepper. Which interval represents the range of possible profit one year from now for
Happy Jalapenos?
A. 200 to 100
B. 110 to 190
C. 100 to 200
D. 190 to 390
E. 200 to 400
2.38 (FM Sample Exam, Q.9) You are given the following information:
The current price to buy one share of ABC stock is 100
The stock does not pay dividends
The risk-free rate, compounded continuously, is 5%
European options on one share of ABC stock expiring in one year have the following prices:
Strike Price
Call option price
Put option price
90
14.63
0.24
100
6.80
1.93
110
2.17
6.81
A butterfly spread on this stock has the following profit diagram.
6
4
2
85
90
95
100
105
110
115
120
-2
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Solutions to Problems:
2.1. (20%)(60) + (30%)(80) + (30%)(100) + (20%)(120) = 90.
2.2. D. (20%)(0) + (30%)(0) + (30%)(100 - 85) + (20%)(120 - 85) = 11.5.
2.3. A. (20%)(85 - 60) + (30%)(85 - 80) + (30%)(0) + (20%)(0) = 6.5.
2.4. Graph of the future value of a European call with strike price of 100, E[(S - 100)+]:
Option Value
140
120
100
80
60
40
20
50
100
150
200
250
Stock Price
2.5. Graph of the future value of a European put with strike price of 100, E[(100 - S)+]:
Option Value
100
80
60
40
20
50
100
150
200
250
Stock Price
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2.6. Graph of the payoff of a European call plus put each with strike price of 100,
E[(S - 100)+] + E[(100 - S)+]:
Payoff
100
80
60
40
20
50
100
150
200
Stock Price
Comment: This straddle pays a large amount if the future stock price differs a lot from $100.
If $100 is the current price, this is one way to speculate on volatility.
Similar to Figure 3.10 in Derivatives Markets by McDonald.
2.7. The payoff for the portfolio is: (ST - 60)+ - 2(ST - 70)+ + (ST - 80)+.
If ST 60, then the payoff is nothing.
If 70 ST > 60, then the payoff is: ST - 60.
If 80 ST > 70, then the payoff is: (ST - 60) - 2(ST - 70) = 80 - ST.
If ST > 80, then the payoff is: (ST - 60) - 2(ST - 70) + (ST - 80) = 0.
A graph of the payoff:
Payoff
10
8
6
4
2
50
60
70
80
90
100
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2.8. The payoff for the portfolio is: (100 - ST)+ - (120 - ST)+.
If ST 120, then the payoff is nothing.
If 120 > ST 100, then the payoff is: -(120 - ST) = ST - 120.
If 100 > ST, then the payoff is: (100 - ST) - (120 - ST) = -20.
A graph of the payoff:
Payoff
60
80
100
120
140
160
-5
- 10
- 15
- 20
Comment: The premium for the 100 strike put is less than the premium for the 120 strike put.
Joe gained money from setting up this portfolio. Joe is hoping that the future stock price will be at
least 120. Similar to Figure 3.7 in Derivatives Markets by McDonald.
2.9. The payoff for the portfolio is: (ST - 90)+ - (90 - ST)+ - (ST - 130)+ + (130 - ST)+.
If ST 90, then the payoff is: -(90 - ST) + (130 - ST) = 40.
If 130 ST > 90, then the payoff is: (ST - 90) + (130 - ST) = 40.
If ST > 130, then the payoff is: (ST - 90) - (ST - 130) = 40. A graph of the payoff:
Payoff
80
60
40
20
S
80
100
120
140
Comment: The box-spread has a risk free payoff; buying a box-spread is equivalent to buying a
bond. Writing a box-spread is equivalent to borrowing money.
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2.10. The payoff for the portfolio is: 2(ST - 100)+ - 3(ST - 110)+ + (ST - 130)+.
If ST 100, then the payoff is nothing.
If 110 ST > 100, then the payoff is: 2(ST - 100).
If 130 ST > 110, then the payoff is: 2(ST - 100) - 3(ST - 110) = 130 - ST.
If ST > 130, then the payoff is: 2(ST - 100) - 3(ST - 110) + (ST - 130) = 0. A graph of the payoff:
Payoff
20
15
10
5
S
80
100
120
140
Comment: As will be discussed, such a Asymmetric Butterfly Spread may be used to take
advantage of certain arbitrage opportunities. = (130 - 110)/(130 - 100) = 2/3.
Buy of the lowest strike, sell 1 of the middle strike, and buy (1 - ) of the highest strike.
In this case, buy 2/3 of 100 strike, sell 1 of the 110 strike, and buy 1/3 of the 130 strike.
Here Amanda has multiplied this position by three.
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- 50
100
110
120
130
140
150
-1 0 0
70
80
90
100
110
S
120
- 20
- 30
Comment: I only graphed from a future stock price of 60 to 120. If ST = 60, then the person to
whom Tiffany sold the put will require Tiffany to buy the stock for 90 from this person, even though
the stock is only worth 60. If ST = 60, then Tiffany has a payoff of 60 - 90 = -30.
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2.13. The payoff for the portfolio is: (70 - ST)+ - (ST - 90)+.
If ST 70, then the payoff is: 70 - ST.
If 90 ST > 70, then the payoff is: 0.
If ST > 90, then the payoff is: ST - 90.
A graph of the payoff:
Payoff
20
10
50
60
70
80
90
100
110
- 10
- 20
Comment: Similar to Figure 3.8 in Derivatives Markets by McDonald.
2.14. B. Harolds bought a call and sold the otherwise similar put.
The payoff on Harolds position is: (S2 - 80)+ - (80 - S2 )+ = S2 - 80.
Since ABC pays no dividends, the prepaid forward price for S2 is just S0 = 78.
The prepaid forward price to receive $80 two years from now is 80e-2r.
Therefore, the price for Harrys position is: 78 - 80e-2r.
Set 6.33 = 78 - 80e-2r. r = 5.5%.
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2.15. The payoff for the portfolio is: (70 - ST)+ - 4(100 - ST)+ + 3(110 - ST)+.
If ST 70, then the payoff is: (70 - ST) - 4(100 - ST) + 3(110 - ST) = 0.
If 100 ST > 70, then the payoff is: -4(100 - ST) + 3(110 - ST) = ST - 70.
If 110 ST > 100, then the payoff is: 3(110 - ST).
If ST > 110, then the payoff is nothing.
A graph of the payoff:
Payoff
30
25
20
15
10
5
60
80
100
120
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50
60
70
80
90
100
- 100
90
S
100 110 120 130 140
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2.20. Collar: Purchase a put and sell a call with a higher strike price.
For example, Aaron might buy a 90 strike put and sell a 110 strike call, each of which expire 6
months from now. (There are many other possible Collars.)
Then the value of his portfolio 6 months from would be: S.5 + (90 - S.5)+ - (S.5 - 110)+.
If S.5 90, then Aarons portfolio is worth 90. (Aaron will use his put to sell the stock for 90.)
If 90 < S.5 < 110, then Aarons portfolio is S.5.
If S.5 110, then Aarons portfolio is worth 110. (The person to whom Aaron sold the call, will use
the call to buy the stock for 110 from Aaron.)
By buying this collar, Aaron has limited the value of his position in 6 months to be between 90 and
110. Aaron can not make a lot, but also he can not lose a lot.
Comment: Using the Black-Scholes formula, to be discussed subsequently, if the stock pays no
dividends, the stock has a volatility of 30%, and r = 5%, then the premium for this collar is -2.60; in
other words, Aaron will make more money from selling the call than he spends buying the put.
If instead for example, Aaron had bought a 120 strike put and sold a 140 strike call, each of which
expire 2 years from now, then he would have limited the value of his position in 2 years to be
between 120 and 140.
2.21. Warren could buy one thousand 1-year at-the money European puts on XYZ stock.
If one year from now XYZ stock is worth more than its current price, then he can sell his stock and
make more in capital gains than he has currently.
If one year from now XYZ stock is worth less than its current price, then he could use his puts to sell
his stock at its price today and make in capital gains the amount he has currently.
Comment: Buying a put protects against the price of a stock you own going down.
Buying a call would protect against the price of a stock you shorted going up.
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15
10
S
90
100
110
120
The purchaser of the straddle hopes that the stock price moves a lot; the purchaser is betting that
there will be high volatility in the stock price.
Payoff diagram for the butterfly spread:
Payoff
10
8
6
4
2
S
100
110
120
130
The purchaser of the butterfly spread hopes that the stock price does not move a lot; the purchaser
is betting that there will be low volatility in the stock price.
2.26. D. (90 - S)+ - (110 - S)+ is equal to:
110 - S, for S > 100,
0, for 90 < S < 110
90 - S, for S < 90.
Comment: This position is called a Collar.
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2.27. E. Statement number 1 is false. A European options can be exercised only on the expiration
date. The statement is the correct definition for an American option.
Statement number 2 is false. In fact, the opposite is true: the lower the market price on the expiration
date, the higher the value of the put option.
Statement number 3 is correct. Short sellers sell stock which they do not yet own.
S - Q if S Q
2.28. (a) (S - Q)+ =
.
0 if S < Q
0 if S Q
(Q - S)+ =
.
Q - S if S < Q
S - Q if S Q
Therefore, (S - Q)+ + (Q - S)+ =
= |S - Q|.
Q - S if S < Q
S - Q if S Q
0 if S Q
(b) (S - Q)+ =
. (Q - S)+ =
.
0 if S < Q
Q - S if S < Q
S - Q if S Q
Therefore, (S - Q)+ - (Q - S)+ =
= S - Q.
S - Q if S < Q
Comment: If Q were a constant, then (S - Q)+ + (Q - S)+ would be the payoff on a Q-strike call and
the similar Q-Strike put; in other words the payoff on a straddle is: (S - K)+ + (K - S)+ = |S - K|.
If Q were a constant, then (S - Q)+ - (Q - S)+ would be the payoff on a Q-strike call and the sale of a
similar Q-Strike put. The fact that (S - K)+ - (K - S)+ = S - K, is the basis of put-call parity, to be
discussed in a subsequent section.
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(90, 10)
(80, 0)
(100, 0)
S
80
90
100
b. The investor is betting that the volatility of the stock will be less than the market expects.
The investor has a large payoff if the stock price moves a small amount from its initial price, and no
payoff if the stock price moves a large amount from its initial price.
Comment: This is a Butterfly spread; there would have been a net cost to setting up this position.
2.30. If the price of hogs in one year is $55 or more, then Mr. Slob gets his bonus.
We can approximate such a payoff by buying a 54-strike call and selling a 56-strike call.
0 if S < 54
2 if S > 56
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2.31. D. If the stock price goes down, the put will have a positive payoff, so Statement #1 is true.
Owning a share and also selling a share short, you will be unaffected by stock price movements, so
Statement #2 is true.
If the stock price goes down, the call will have no payoff; you can use the money you got from
selling the call to offset some of the losses on the stock. Thus Statement #3 is true.
Comment: Buying a put would be the usual way to hedge the risk of the stock price declining.
2.32. a. When a firm borrows, the equity holders exchange their claim on the assets of the firm for a
call option on the whole firm with an strike price equal to the maturity value of the debt. In other
words, the option holder can either exercise the call option at the exercise date, pay the strike price,
and obtain the stock, or the option holder can choose not to exercise the call option and he or she is
left with no stock. Similarly, the equity holders can either repay the debt at the maturity date for the
par value and retain the assets of the corporation, or they can default on the debt, in which case they
are left with nothing since the bondholders take the assets of the corporation.
b. There is still a chance that the asset of the company will increase beyond $50 million by the end
of the second year, so the stock still has value. This is equivalent to an out-of-the money call with a
year until expiration; such a call has a positive if small value.
c. The companys assets are less than the money owed to the bondholders, so the stock is now
worthless. An out-of-the money call at expiration is worthless.
2.33. a. The actuary's family has a claim on the future wages of the actuary. If the actuary dies, the
value of that claim falls to zero. The term life policy is like a put option which pays off if the actuary
dies over the term of the policy.
b. Events other than death can reduce the actuary's future wages, for example layoff or disability.
Under these events, the term life policy will not pay off.
Comment: The analogy is a little strained.
2.34. D. This is the diagram for selling (writing) a straddle, position #2.
If there are no dividends, then by put call parity, the buying a call is equivalent to buying one share
of stock, buying one puts, and borrowing the present value of the strike.
Thus, in this case, position #3 would be equivalent to selling a call and selling a put, position #2.
The value of position #1 at future time T is: -ST - 100, not the given graph.
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15
20
25
30
35
40
Loss
0, S < 20
10, S > 30
Comment: Many insurance and reinsurance arrangements can be thought of in terms of options.
2.36. a. If in two years the lot is worth more than $200,000, then Norbert will use its call to
repurchase the lot for $200,000. If in two years the lot is worth less than $200,000, then the put
Norbert gave the buyer will be used to sell the lot to Norbert for $200,000.
b. Norbert gets a net of $200,000 - $40,000 = $160,000 today.
In either case, two years from now Norbert will reacquire the lot and will pay the buyer $200,000.
Norbert has borrowed $160,000 from the buyer and repaid the buyer $200,000 in 2 years.
Interest rate for this loan = (200,000/160,000)1/2 - 1 = 11.8%.
2.37. D. The accumulated cost of the hedge is: (84.30 - 74.80)exp(.06) = 10.09.
Let x be the market price.
If x < 0.12, the put is in the money and the payoff is: 10,000(0.12 x) = 1,200 - 10,000x.
The sale of the jalapenos has a payoff of: 10,000x - 1,000.
The profit is: 1,200 - 10,000x + 10,000x - 1,000 - 10.09 = 190.
From 0.12 to 0.14 neither option has a payoff, and the profit is:
10,000x - 1,000 - 10.09 = 10,000x - 1,010. This ranges from 190 to 390.
If x > 0.14, the call is in the money and the payoff is: -10,000(x - 0.14) = 1,400 - 10,000x.
The profit is: 1,400 - 10,000x + 10,000x - 1,000 - 10.09 = 390.
The range of possible profit one year from now is: 190 to 390.
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2.38. D. The cost to set up portfolio A is: 0.24 + 6.81 - (2)(1.93) = 3.19.
If S1 < 90, then the profit is: (90 - S1 ) + (110 - S1 ) - 2(100 - S1 ) - 3.19e0.05 = -3.35.
If 90 < S1 < 100, then the profit is: (110 - S1 ) - 2(100 - S1 ) - 3.19e0.05 = S1 - 93.35.
If S1 = 100, then the profit is: 10 - 3.19e0.05 = 6.65.
If 100 < S1 < 110, then the profit is: (110 - S1 ) - 3.19e0.05 = 106.65 - S1 .
If 110 < S1 , then the profit is: -3.19e0.05 = -3.35.
The cost to set up portfolio B is: 14.63 + 2.17 - (2)(6.80) = 3.20.
If S1 < 90, then the profit is: -3.20e0.05 = -3.36.
If 90 < S1 < 100, then the profit is: (S1 - 90) - 3.20e0.05 = S1 - 93.36.
If S1 = 100, then the profit is: 10 - 3.20e0.05 = 6.64.
If 100 < S1 < 110, then the profit is: (S1 - 90) - 2(S1 - 100) - 3.20e0.05 = 106.64 - S1 .
If 110 < S1 , then the profit is: (S1 - 90) - 2(S1 - 100) + (S1 - 110) - 3.20e0.05 = -3.36.
The cost to set up portfolio C is: 0.24 + 2.17 - 6.80 - 1.93 = -6.32.
If S1 < 90, then the profit is: (90 - S1 ) - (100 - S1 ) + 6.32e0.05 = -3.36.
If 90 < S1 < 100, then the profit is: -(100 - S1 ) + 6.32e0.05 = S1 - 93.36.
If S1 = 100, then the profit is: 6.32e0.05 = 6.64.
If 100 < S1 < 110, then the profit is: -(S1 - 100) + 6.32e0.05 = 106.64 - S1 .
If 110 < S1 , then the profit is: -(S1 - 100) + (S1 - 110) + 6.32e0.05 = -3.36.
The cost to set up portfolio D is: 100 + 14.63 + 6.81 - (2)(1.93) = 117.68.
If S1 < 90, then the profit is: S1 + (110 - S1 ) - 2(100 - S1 ) - 117.68e0.05 = 2S1 - 213.71,
not matching the given graph.
If 90 < S1 < 100, then the profit is: S1 + (S1 - 90) + (110 - S1 ) - 2(100 - S1 ) - 117.68e0.05
= 3S1 - 303.71, not matching the given graph.
If S1 = 100, then the profit is: 100 + 10 + 10 - 117.68e0.05 = -3.71, not matching the given graph.
If 100 < S1 < 110, then the profit is: S1 + (S1 - 90) + (110 - S1 ) - 117.68e0.05 =
S 1 - 103.71, not matching the given graph.
If 110 < S1 , then the profit is: S1 + (S1 - 90) - 117.68e0.05 = 2S1 - 213.71, not matching the given
graph.
The cost to set up portfolio E is: 100 + 0.24 + 2.17 - (2)(6.80) = 88.81.
If S1 < 90, then the profit is: S1 + (90 - S1 ) - 88.81e0.05 = -3.36.
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50
100
150
200
The actuarial present value, in other words premium, of the call decreases as the strike
price increases and the curve is concave upwards.
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For example, assume the future price of a stock at expiration of a call has the following distribution:
$50 @ 20%, $100 @ 40%, $150 @30%, $200 @10%.
Stock
Price
50
100
150
200
Payoff on Call
with K = 90
0
10
60
110
Payoff on Call
with K = 100
0
0
50
100
Difference
0
10
10
10
C
-1.
K
Since European options can only be exercised at expiration, the difference in option premiums
cannot be more than the present value of the difference in payoffs. Thus:
C
For K1 < K2 , C(K1 ) - C(K2 ) e-rT (K2 - K1 ).63
-e-rT.
K
57
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The third property is referred to as the convexity of the option price with respect to the strike price.64
.
K 2 - K1
K 3 - K2
2C
0.
K2
For example, let us assume that a call with strike price $90 is worth $7 more than a similar call with a
strike price of $100. Then a call with a strike price of $100 exceeds that of a similar call with a strike
price of $110, but by less than or equal to $7.
Convexity follows from the fact that the second derivative of the call premium with respect to K is
positive:
2C
0. C decreases as K increases and the slope is negative; as K increases the slope
K2
increases, in other words gets closer to zero. As K decreases the slope decreases; however, the
slope can not get less than -1.
As mentioned before, the graph of C as a function of K is concave upwards.
64
A convex function has a curve that is concave upwards, shaped like a bowl.
See equation 9.19 in Derivatives Markets by McDonald. This equation holds both for European and American
options, to be discussed subsequently.
66
Increased Limits Factors share this same property for the same underlying mathematical reason.
See Sheldon Rosenbergs review of On the Theory of Increased Limits and Excess of Loss Pricing, PCAS 1977.
65
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Mathematically the three conditions for call premiums could be summarized as:
-1
C
2C
0, and
0.
K
K2
50
100
150
200
As K approaches zero, the slope of the above curve approaches -e-rT, which is close to but more
than minus one. As K approaches infinity, the slope of the above curve approaches 0.
67
The put premiums are computed via the Black-Scholes formula to be discussed subsequently.
This is for a 2-year European call, and = 40%, r = 6%, = 0.
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E[(ST - K)+] =
{1 - F(x)} dx .
68
{1 - F(x)} dx .
C
= -e-rT{1 - F(K)} 0.
K
Therefore, C declines as K increases.
K2
{1 -
K1
2C
= e-rT f(K) 0.
K2
Therefore, C(K) is concave upwards.
68
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As K increases, the area above the horizontal line at height K decreases; in other words, the value of
the call decreases as K increases.
70
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For an increase in K of K, the value of the call decreases by Area A in the following Lee Diagram:
Stock Price
K+K
K
Prob.
The absolute value of the change in the value of the call, Area A, is smaller than a rectangle of height
K and width 1 - F(K). Thus Area A is smaller than K {1 - F(K)} K. Thus a change of K in the
strike price results in a absolute change in the value of the call option smaller than K.
The following Lee Diagram shows the effect of raising the strike price by fixed amounts:
The successive absolute changes in the value of the call are represented by Areas A, B, C, and D.
We see that the absolute changes in the value of the call get smaller as the strike price increases.
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60
40
20
60
80
100
120
140
160
180
200
The actuarial present value of the put increases as the strike price increases and the
curve is concave upwards.
These are general properties for the behavior of a put as one varies the strike price.72
72
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P
0.
K
For example, the value of an put option with strike price $100 is greater than an otherwise similar put
with a strike price of $90. It is more valuable to have the option to sell at $100 than to have the
option to sell at $90.
For K1 < K2 , P(K2 ) - P(K1 ) K2 - K1 .75 76
P
1.
K
For example, the value of a put option with strike price $100 is greater than an otherwise similar put
with a strike price of $90 by at most $10. Being able to sell at $100 is worth at most $10 more than
being able to sell at $90.77
Since European options can only be exercised at expiration, the difference in option premiums
cannot be more than the present value of the difference in payoffs. Thus:
P
For K1 < K2 , P(K2 ) - P(K1 ) e-rT (K2 - K1 ).78
e-rT.
K
.
K 2 - K1
K 3 - K2
2P
0.
K2
For example, let us assume that a put with strike price $100 is worth $6 more than a similar put with a
strike price of $90. Then a put with a strike price of $110 exceeds that of a similar put with a strike
price of $100 by at least $6.
This is referred to as the convexity of the option price with respect to the strike price.80 It follows from
the fact that the second derivative of the value of the put with respect to K is positive:
2P
0.
K2
P increases as K increases and the slope is positive; as K increases the slope increases, in other
words gets further from zero. However, the slope can not exceed one.
73
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P
2P
0, and
0.
K
K2
10
40
60
80
100
As K approaches infinity, the slope of the above curve approaches e-rT, which is close to but less
than one. As K approaches zero, the slope of the above curve approaches 0.
81
The graph of a function is concave upwards if it is shaped like a bowl. If the second derivative is positive, then the
graph of a function is concave upwards. A convex function is such that for any 0 t 1, and x y,
f(tx + (1-t)y) tf(x) + (1 -t)f(y). A convex function has a graph that is concave upwards.
82
The put premiums are computed via the Black-Scholes formula to be discussed subsequently.
This is for a 2-year European put, and = 40%, r = 6%, = 0.
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E[(K - ST)+] =
F(x) dx .
0
F(x) dx .
0
P
= e-rT F(K) 0.
K
Therefore, P increases as K increases.
K2
K1
2P
= e-rT f(K) 0.
K2
Therefore, P(K) is concave upwards.
83
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As K increases, the area below the horizontal line at height K increases; in other words, the value of
the put increases as K increases.
84
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For an increase in K of K, the value of the put increases by Area A in the following Lee Diagram:
Stock Price
K+K
K
Prob.
The change in the value of the put, Area A, is smaller than a rectangle of height K and width
F(K +K). Thus Area A is smaller than K F(K +K) K. Thus a change of K in the strike price
results in a change in the value of the put option smaller than K.
The following Lee Diagram shows the effect of raising the strike price by fixed amounts:
The successive changes in the value of the put are represented by Areas A, B, C, and D.
We see that the changes in the value of the put get larger as the strike price increases.
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Arbitrage:
If there is a possible combination of buying and selling with no net investment that has
no risk but generates positive (or at least nonnegative) cashflows, this is an arbitrage
opportunity. Taking advantage of such an opportunity is called arbitrage. In other words,
arbitrage is free money.
If an arbitrage opportunity existed, clever traders would take advantage of it. Relatively quickly, the
prices would adjust so as to remove this opportunity for arbitrage.
Generally, we assume prices should be such that they do not permit arbitrage. In other words, we
assume that there is no free lunch. This is called no-arbitrage pricing.
Arbitrage Opportunities with Two Calls:
If one of the general properties of option premiums that has been discussed is violated, that creates
an opportunity for arbitrage.
For example, two otherwise similar calls have the following premiums:
100 strike call costs 10.
110 strike call costs 12.
This violates the principal that call premiums should not increase as the strike price increases.
The 100 strike call is cheap relative to the 110 strike call; the 110 strike call is expensive relative to
the 100 strike call.
We can buy a 100 strike call and sell a 110 strike call.
We make 12 - 10 = 2 from this set of transactions.
We invest the 2 at the risk free rate, r.
At expiration of the calls at time T, we have:
If S 100: 2erT > 0
If 110 S > 100: (S - 100) + 2erT > 0.
If S > 110: (S - 100) - (S - 110) + 2erT = 10 + 2erT > 0.
Thus we always end up with a positive (or at least nonnegative) position, having taken no risk.
This demonstrates arbitrage.
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In another example, two otherwise similar calls have the following premiums:
100 strike call costs 20.
105 strike call costs 13.
This violates the principal that call premiums should not decrease by more than the increase of the
strike price. The 105 strike call is cheap relative to the 100 strike call.
We can sell a 100 strike call and buy a 105 strike call.
We make 20 - 13 = 7 from this set of transactions.
We invest the 7 at the risk free rate, r.
At expiration of the calls at time T, we have:
If S 100: 7erT > 0
If 105 S > 100: -(S - 100) + 7erT 7erT - 5 > 0.
If S > 105: (S - 100) - (S - 105) + 7erT = 7erT - 5 > 0.
Thus we always end up with a positive (or at least nonnegative) position, having taken no risk.
This demonstrates arbitrage.
If the principals for put premiums are violated, one can set up similar opportunities for arbitrage to
those illustrated for calls.
Arbitrage Opportunities When Convexity is Violated by Call Premiums:
Three otherwise similar calls have the following premiums:
100 strike call costs 20.
110 strike call costs 17.
140 strike call costs 7.
(20 - 17) / (110 - 100) = 0.3.
0.333 > 0.3. This violates the convexity of the call premium with respect to the strike price.
The arbitrage opportunity in such situations involves buying some of the low strike and high strike
calls, while selling some of the medium strike calls. While there are many possible positions that
demonstrate arbitrage when convexity is violated, McDonald has a technique of coming up with one
such a portfolio.
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Let =
Page 77
K3 - K2 85
.
K 3 - K1
is the amount of the distance between the high and medium strike prices as a fraction of the
distance between the high and low strike prices. In this example, = (140 - 110) / (140 -100) = 3/4.
We note that K2 = K1 + (1 - )K3 , a weighted average of K1 and K3 with weights and 1 - .
In this example, 110 = (3/4)(100) + (1 - 3/4)(140).
The convexity relationship for call premiums was:
For K1 < K2 < K3 , {C(K1 ) - C(K2 )} / {K2 - K1 } {C(K2 ) - C(K3 )} / {K3 - K2 }.
K3 - K
.
K3 - K 1
Thus, we require that the point (K2 , C(K2 )) not be above this line.
85
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For this example, here is the line, as well as the premiums for the three calls:
C
20
17
100
110
140
Convexity is violated because the point (110, 17) is above the line.87
In other words, the curve of option premium as a function of strike price is not concave upwards.88
87
88
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In order to demonstrate arbitrage when convexity is violated, in general, one can buy of the
lowest strike call, buy 1 - of the high strike call, and sell 1 of the medium strike call.89 90
In this example, we buy 3/4 of the 100 strike calls, buy 1/4 of the 140 strike calls, and sell 1 of the
110 strike calls. Equivalently, we can buy 3 of the 100 strike calls, buy 1 of the 140 strike calls, and
sell 4 of the 110 strike calls.
When we set up this portfolio, we get: (-3)(20) + (4)(17) + (-1)(7) = 1.
We invest this 1 at the risk free rate r.
At expiration of the calls at time T, we have:
If S 100: erT > 0
If 110 S > 100: 3(S - 100) + erT > 0.
If 140 S > 110: 3(S - 100) - (4)(S - 110) + erT = 140 - S + erT > 0.
If S > 140: 3(S - 100) - (4)(S - 110) + (S - 140) + erT = erT > 0.
Thus we always end up with a positive (or at least nonnegative) position, having taken no risk.
This demonstrates arbitrage.91
Arbitrage Opportunities When Convexity is Violated by Put Premiums:
If convexity for put premiums are violated, one can set up similar opportunities for arbitrage.
For example, three otherwise similar puts have the following premiums:
80 strike put costs 12.
100 strike put costs 18.
110 strike put costs 20.
(18 - 12) / (100 - 80) = 0.3.
0.2 < 0.3. This violates the convexity of the put premium with respect to the strike price.
As with calls, the arbitrage opportunity in such situations involves buying some of the low strike and
high strike option, while selling some of the medium strike option. While there are many possible
positions that demonstrate arbitrage when convexity is violated, one can use the same technique of
coming up with one such a portfolio as was discussed for calls.
89
One could multiply all of the amounts by a constant in order to make them integer.
Since convexity is violated, C(K2 ) > C(K1 ) + (1 -) C(K3 ). Therefore, the medium strike call is overpriced relative
to this weighted average of the low strike and high strike calls. Therefore, we sell the medium strike call.
91
Recall, that there are other portfolios that would also demonstrate arbitrage.
90
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C(K1 ) C(K2 ).
Buy the K1 Call and Sell the K2 Call (Call Bull Spread)
C(K1 ) - C(K2 ) K2 - K1 .
Sell the K1 Call and Buy the K2 Call (Call Bear Spread)
C(K1) - C(K2 )
K2 - K1
C(K2) - C(K3 )
.
K3 - K2
P(K2 ) P(K1 ).
Sell the K1 Put and Buy the K2 Put (Put Bear Spread)
P(K2 ) - P(K1 ) K2 - K1 .
Buy the K1 Put and Sell the K2 Put (Put Bull Spread)
P(K2 ) - P(K 1)
K2 - K1
92
P(K3 ) - P(K 2)
.
K3 - K2
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Problems:
Use the following information for the next 4 questions:
The price of the stock of the Willy Wonka Chocolate Company 6 months from now has the
following distribution:
Price Probability
100 20%
150 40%
200 30%
250 10%
The continuously compounded annual rate of interest is 5%.
3.1 (1 point) Determine the expected payoff of a 6 month European call option on one share of
Willy Wonka Chocolate Company, with a strike price of 180.
A. 12
B. 13
C. 14
D. 15
E. 16
3.2 (1 point) Determine the expected payoff of a 6 month European put option on one share of
Willy Wonka Chocolate Company, with a strike price of 160.
A. 12
B. 13
C. 14
D. 15
E. 16
3.3 (1 point) Determine the actuarial present value of a 6 month European call option on one share
of Willy Wonka Chocolate Company, with a strike price of 170.
A. 16.0
B. 16.2
C. 16.4
D. 16.6
E. 16.8
3.4 (1 point) Determine the actuarial present value of a 6 month European put option on one share
of Willy Wonka Chocolate Company, with a strike price of 170.
A. 19.5
B. 20.0
C. 20.5
D. 21.0
E. 21.5
3.5 (1 point) 3 European put options on a stock are otherwise similar except for their strike price.
A put with a strike price of 150 has a premium of 30, in other words costs 30.
A put with a strike price of 160 has a premium of 34, in other words costs 34.
A put with a strike price of 180 has a premium of 40, in other words costs 40.
What general property of the value of puts is violated?
3.6 (3 points) Briefly describe an opportunity for arbitrage presented by the situation in the
previous question.
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3.7 (1 point) Two European put options on a stock are otherwise similar except for their strike price.
A put with a strike price of 60 has a premium of 7.
A put with a strike price of 80 has a premium of 15.
Which of the following is true about the premium of a similar 70 strike put?
A. The smallest possible premium is 8
B. The smallest possible premium is 11
C. The largest possible premium is 8
D. The largest possible premium is 11
E. None of A, B, C, or D
3.8 (1 point) Two European call options on a stock are otherwise similar except for their strike price.
A call with a strike price of 100 has a premium of 27, in other words costs 27.
A call with a strike price of 110 has a premium of 15, in other words costs 15.
What general property of the value of calls is violated?
3.9 (2 points) Briefly describe an opportunity for arbitrage presented by the situation in the
previous question.
3.10 (1 point) Two European call options on a stock are otherwise similar except for their strike price.
A call with a strike price of 80 has a premium of 12.
A call with a strike price of 85 has a premium of 10.
Which of the following is true about the premium of a similar 100 strike call?
A. The smallest possible premium is 2
B. The smallest possible premium is 4
C. The largest possible premium is 2
D. The largest possible premium is 4
E. None of A, B, C, or D
3.11 (1 point) 2 European put options on a stock are otherwise similar except for their strike price.
A put with a strike price of 150 has a premium of 22, in other words costs 22.
A put with a strike price of 170 has a premium of 46, in other words costs 46.
What general property of the value of puts is violated?
3.12 (2 points) Briefly describe an opportunity for arbitrage presented by the situation in the
previous question.
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3.13 (3 points) European call and put prices for options on a given stock are available as follows:
Strike Price Call Price
Put Price
$50
$21
$3
$60
$16
$7
$80
$8
$14
All six options have the same expiration date, which is no more than two years from now.
After reviewing the information above, Danielle, Eric, and Felicia agree that arbitrage opportunities
arise from these prices.
Danielle believes that one could use the following portfolio to obtain arbitrage profit: Long two calls
with strike price 50; short four calls with strike price 60; long two calls with strike price 80; and either
lend or borrow some money.
Eric believes that one could use the following portfolio to obtain arbitrage profit: Long two puts with
strike price 50; short three puts with strike price 60; long one put with strike price 80; and either lend
or borrow some money.
Felicia believes that one could use the following portfolio to obtain arbitrage profit: Short one call with
strike price 50; long two calls with strike price 60; short one call with strike price 80; long one put with
strike price 50; short two puts with strike price 60; long one put with strike price 80; and either lend or
borrow some money.
Which of the following statements is true?
(A) Danielle and Eric are correct, while Felicia is not.
(B) Danielle and Felicia are correct, while Eric is not.
(C) Eric and Felicia are correct, while Danielle is not.
(D) All of them are correct.
(E) None of A, B, C, or D.
3.14 (1 point) 3 European call options on a stock are otherwise similar except for their strike price.
A call with a strike price of 100 has a premium of 25, in other words costs 25.
A call with a strike price of 110 has a premium of 20, in other words costs 20.
A call with a strike price of 115 has a premium of 16, in other words costs 16.
What general property of the value of calls is violated?
3.15 (3 points) Briefly describe an opportunity for arbitrage presented by the situation in the
previous question.
3.16 (1 point) Two European call options on a stock are otherwise similar except for their strike price.
A call with a strike price of 120 has a premium of 22, in other words costs 22.
A call with a strike price of 125 has a premium of 16, in other words costs 16.
What general property of the value of calls is violated?
3.17 (2 points) Briefly describe an opportunity for arbitrage presented by the situation in the
previous question.
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3.18 (1 point) Two European call options on a stock are otherwise similar except for their strike price.
A call with a strike price of 80 has a premium of 12, in other words costs 12.
A call with a strike price of 90 has a premium of 14, in other words costs 14.
What general property of the value of calls is violated?
3.19 (2 points) Briefly describe an opportunity for arbitrage presented by the situation in the
previous question.
3.20 (2 points) Two European call options are otherwise similar except for their strike prices.
A call with a strike price of 85 has a premium of 13.
A call with a strike price of 90 has a premium of 7.
In order to take advantage of arbitrage, you buy 1000 of the 90 strike calls and sell x of the 85 strike
calls. If r = 0%, what is the smallest possible value of x?
A. 800
B. 825
C. 850
D. 875
E. 900
3.21 (2 points) A long range forward contract consists of buying a call, and selling a similar put with a
lower strike but the same time until expiration, where the strikes are chosen so that the contract has
no initial cost.
The current exchange rate is 1.58 Canadian Dollars per British Pound.
The company Bright, Light, and Powers is based in Canada. It will have to make a payment of
100,000 British Pounds in 4 months.
In order to limit its risk, the company buys a 4-month long range forward contract on 100,000 British
Pounds. The strike of the call is 1.65 Canadian Dollars. The strike of the put is 1.50 Canadian Dollars.
Graph as a function of the future exchange rate the amount of Canadian Dollars that Bright, Light, and
Powers has to spend 4 months from now in order to make its payment of 100,000 British Pounds.
3.22 (1 point)
The price of a stock one year from now has the following distribution in the risk neutral environment:
Price Probability
50 10%
100 20%
150 40%
200 20%
250 10%
Let X be the expected future value of a 1 year European call option on 100 shares of this stock with
a strike price of 170.
Let Y be the expected future value of a 1 year European put option on 100 shares of this stock with
a strike price of 140.
Determine Y - X.
A. 150
B. 200
C. 250
D. 300
E. 350
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3.23 (MFE Sample Exam, Q.2) Near market closing time on a given day, you lose access to
stock prices, but some European call and put prices for a stock are available as follows:
Strike Price Call Price
Put Price
$40
$11
$3
$50
$6
$8
$55
$3
$11
All six options have the same expiration date.
After reviewing the information above, John tells Mary and Peter that no arbitrage opportunities can
arise from these prices.
Mary disagrees with John. She argues that one could use the following portfolio to obtain arbitrage
profit: Long one call option with strike price 40; short three call options with strike price 50; lend $1;
and long some calls with strike price 55.
Peter also disagrees with John. He claims that the following portfolio, which is different from Marys,
can produce arbitrage profit: Long 2 calls and short 2 puts with strike price 55; long 1 call and short 1
put with strike price 40; lend $2; and short some calls and long the same number of puts with strike
price 50.
Which of the following statements is true?
(A) Only John is correct.
(B) Only Mary is correct.
(C) Only Peter is correct.
(D) Both Mary and Peter are correct.
(E) None of them is correct.
3.24 (IOA CT8, 4/09, Q.1) (2.25 points) Describe what is meant by an arbitrage opportunity.
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Solutions to Problems:
3.1. B. E[(S - 180)+] = (20%)(0) + (40%)(0) + (30%)(20) + (10%)(70) = 13.
Comment: If the future price is low, then the option to buy at 180 is worthless.
We have ignored the time value of money.
3.2. E. E[(160 - S)+] = (20%)(60) + (40%)(10) + (30%)(0) + (10%)(0) = 16.
Comment: If the future price is high, then the option to sell at 160 is worthless.
3.3. D. E[(S - 170)+] e-rT = {(20%)(0) + (40%)(0) + (30%)(30) + (10%)(80)} e-(0.05)(1/2) = 16.58.
3.4. E. E[(170 - S)+] e-rT = {(20%)(70) + (40%)(20) + (30%)(0) + (10%)(0)} e-(0.05)(1/2) = 21.46.
3.5. & 3.6. The absolute value of the changes in the value of the option over the absolute value of
the changes in the strike price are: (34 - 30) / (160 - 150) = 0.4, and (40 - 34) / (180 - 160) = 0.3.
0.4 > 0.3, which violates the proposition that the rate of change of the put option premium must
increase as the strike price rises. In other words, convexity is violated.
= (180 - 160)/(180 - 150) = 2/3. We can buy 2/3 puts with strike price 150, buy 1/3 puts with a
strike price of 180, and sell 1 put with strike price 160. Equivalently, we can buy 2 puts with strike
price 150, buy 1 put with a strike price of 180, and sell 3 puts with strike price 160.
Then you collect a net of: (3)(34) - (2)(30) - (1)(40) = 2.
You could invest this 2 at the risk free rate and have 2erT at the expiration of the options.
If ST 180, then all the puts turn out to worthless. You end up with 2erT 2.
If 180 > ST 160, then the put that you have bought with strike price of 180 will be exercised.
You will make 180 - ST by exercising this put. You end up with: 2erT + (180 - ST) 2.
If 160 > ST 150, then the puts that you have sold will be exercised. You will pay (3)(160) = 480
for the 3 shares you buy from the person holding the puts. Then you can sell 1 share at 180 and 2
shares at ST.
You end up with: 2erT + 180 + 2ST - 480 = 2erT + 2ST - 300 2 + (2)(150) - 300 = 2.
If ST < 150, then you will pay (3)(160) = 480 for the 3 shares you buy from the person holding the
puts. Then you can sell 1 share at 180 and 2 shares at 150. You end up with:
2erT + 180 + 300 - 480 = 2erT 2.
In all possible situations you end up with a positive amount at time T, not having invested a positive
amount of money.
Comment: See Example 9.6 in Derivatives Markets by McDonald.
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3.7. D. If the premiums were on a straight line, then the premium at a 70 strike would be 11.
For convexity to hold, the line between (60, 15) and (80, 7) must not be below the point
(70, premium). Therefore, the premium for a 70 strike must be 11 or less.
3.8. & 3.9. The absolute value of the change in the value of the option is: 27 -15 = 12, which is
greater than the absolute value of the change in the strike price: 110 - 100 = 10.
This should not occur.
You could buy a call with strike price 110 and sell a call with strike price 100.
Then you collect a net of: 27 -15 = 12. You could invest this 12 at the risk free rate and have 12erT,
at the expiration of the call options.
If ST 100, then both calls turn out to worthless. You end up with 12erT > 12.
If 110 ST > 100, then the call that you have sold will be exercised. You can buy a share at ST and
then will get 100 for the share when you sell it to the person holding the call you sold.
You end up with: 12erT - (ST - 100) > 12 - 10 = 2.
If ST 110, then the call that you have sold will be exercised, buying a share at 110. Then will get
100 for the share when you sell it to the person holding the call.
You end up with: 12erT - 10 > 12 - 10 = 2.
In all possible situations you end up with a positive amount at time T, not having invested a positive
amount of money.
Comment: See Example 9.4 in Derivatives Markets by McDonald.
Arbitrage is a transaction where you always end up with a positive position, with no net investment
and no risk; in other words, arbitrage represents a free lunch. Arbitrage involves the simultaneous
buying and selling of related assets.
3.10. B. If the premiums were on a straight line, then the premium for a 100 strike would be 4.
For convexity to hold, the line between (80, 12) and (100, premium) must not be below the point
(85, 10). Therefore, the premium for a 100 strike must be 4 or more.
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3.11. & 3.12. The absolute value of the change in the value of the option is: 46 - 22 = 24, which is
greater than the absolute value of the change in the strike price: 170 - 150 = 20.
This should not occur.
You could buy a put with strike price 150 and sell a put with strike price 170.
Then you collect a net of: 46 - 22 = 24. You could invest this 24 at the risk free rate and have 24erT,
at the expiration of the options.
If ST 170, then both puts turn out to worthless. You end up with 24erT > 24.
If 170 > ST 150, then the put that you have sold will be exercised. You buy a share at 170 from
the person who owns the put you sold, and then you sell the share for ST.
You end up with: 24erT - (170 - ST) > 24 - 20 = 4.
If ST < 150, then the put that you have sold will be exercised. You buy a share at 170 from the
person who owns the put you sold, and then you sell the share for 150, using the put you own.
You end up with: 24erT - (170 - 150) > 24 - 20 = 4.
In all possible situations you end up with a positive amount at time T, not having invested a positive
amount of money.
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3.13. C. The call premiums satisfy all three properties, and thus there is no arbitrage opportunity.
If Danielle buys her portfolio of calls, then she would get: (4)(16) - (2)(21) - (2)(8) = 6.
She would lend out 6.
If for example, ST = 80, then the payoff from the calls is: (2)(30) + (-4)(20) + (2)(0) = -20.
Thus she would have 6erT - 20, which is almost surely not positive.
Danielles portfolio does not demonstrate arbitrage.
The put premiums do not satisfy convexity, and thus there are opportunities for arbitrage.
If Eric buys his portfolio of puts, then he would get: (3)(7) - (2)(3) - (1)(14) = 1.
He would lend out 1.
If ST 50, then the puts payoff: (2)(50 - S) - (3)(60 - S) + (1)(80 - S) = 0.
He ends up with erT > 0.
If 50 < ST 60, then the puts payoff: (-3)(60 - S) + (1)(80 - S) = 2S - 100 > 0.
He ends up with more than erT > 0.
If 60 < ST 80, then the puts payoff: (1)(80 - S) > 0.
He ends up with more than erT > 0.
If 80 < ST, then all of the puts expire worthless. He ends up with erT > 0.
Erics portfolio does demonstrate arbitrage.
If Felicia buys her portfolio of puts and calls, then she would spend:
(-1)(21) + (2)(16) + (-1)(8) + (1)(3) + (-2)(7) + (1)(14) = 6.
She would borrow 6.
If ST 50, then the payoff is: (1)(50 - S) + (-2)(60 - S) + (1)(80 - S) = 10.
If 50 < ST 60, then the payoff is: (-1)(S - 50) + (-2)(60 - S) + (1)(80 - S) = 10.
If 60 < ST 80, then the payoff is: (-1)(S - 50) + (2)(S - 60) + (1)(80 - S) = 10.
If 80 < ST, then the payoff is: (-1)(S - 50) + (2)(S - 60) + (-1)(S - 80) = 10.
So she always ends up with 10 - 6erT 10 - 6er2 > 0.
Felicias portfolio does demonstrate arbitrage.
Comment: Similar to MFE Sample Exam, Q.2.
I have assumed that 10 > 6er2. r < 25.5%.
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3.14. & 3.15. The absolute value of the changes in the value of the option over the absolute value
of the changes in the strike price are: (25 - 20)/(110 - 100) = 0.5, and (20 - 16)/(115 - 110) = 0.8.
0.5 < 0.8, which violates the proposition that the rate of absolute change of the call option premium
must decrease as the strike price rises. In other words, convexity is violated.
= (115 - 110)/(115 - 100) = 1/3. We can buy 1/3 calls with strike price 100, buy 2/3 calls with a
strike price of 115, and sell 1 call with strike price 110. Equivalently, we can buy 1 call with strike
price 100, buy 2 calls with a strike price of 115, and sell 3 calls with strike price 110.
Then you collect a net of: (3)(20) - (1)(25) - (2)(16) = 3.
You loan out this 3 and collect interest at the risk free rate.
At expiration of the calls at time T, we have:
If S 100: 3erT > 0
If 110 S > 100: (S - 100) + 3erT > 0.
If 115 S > 110: (S - 100) - (3)(S - 110) + 3erT = 230 - 2S + 3erT > 0.
If S > 115: (S - 100) - (3)(S - 110) + (2)(S - 115) + 3erT = 3erT > 0.
Thus we always end up with a positive (or at least nonnegative) position, having taken no risk.
This demonstrates arbitrage.
Comment: See Example 9.5 in Derivatives Markets by McDonald.
The given call premiums as a function of strike price:
C
25
20
16
100
110
K
115
Since (110, 20) is above the line between (100, 25) and (115, 16), convexity is violated.
The line between (100, 25) and (115, 16) can be written as a weighted average of 25 and 16:
y = 25 + 16 (1 - ), where = (115 - K) / (115 - 100).
At K = K2 = 110, = 1/3 = (K3 - K2 ) / (K3 - K1 ) = ,
and the height of the line is: (25)(1/3) + (16)(2/3) = 19 < 20.
For convexity to hold, we require that: C(K1) + (1 - ) C(K3 ) C(K2 ).
There are other possible portfolios that would demonstrate arbitrage, but the one given in my
solution is based on how in the textbook arbitrage is demonstrated for this situation.
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3.20. D. If the future stock price is ST < 85, then both calls are worthless.
We want 13x - (1000)(7) 0. x > 538.
If the future stock price is 90 > ST > 85, then the 90 strike calls are worthless, but we lose money on
the 85 strike calls we sold. The worst case is when ST = 90 and we lose 5 on each 85 strike call.
We want 13x - (1000)(7) 5x. x 875.
If the future stock price is ST > 90, then we make money on the 90 strike calls, and we lose money
on the 85 strike calls we sold.
We want 13x - (1000)(7) x(ST - 85) - (1000)(ST - 90). x(98 - ST) (1000)(97 - ST).
If 98 - ST > 0, then we require that x (1000)(97 - ST)/(98 - ST) = 1000{1 - 1/(98 - ST)}.
For 90 < ST < 98. The left hand side is largest for ST = 90; (1000)(97 - 90)/(98 - 90) = 875.
We need x 875.
If 98 - ST < 0, then we require that x (1000)(97 - ST)/(98 - ST) = 1000{1 + 1/(ST - 98)}.
Thus we need x 1000.
We conclude that we can take 875 x 1000.
The smallest possible value of x is 875.
Comment: For example, if x = 900, then we get for setting up the portfolio: (900)(13) - (1000)(7) =
4700. If ST < 85 both calls are worthless. If ST = 90, we lose (5)(900) = 4500 on the 85 strike calls
we sold, but still come out ahead. If for example, ST = 100, we lose (15)(900) = 13,500 on the 85
strike calls we sold, and make (1000)(10) = 10,000 on the 90 strike calls we bought, for a net loss of
3500; but we still come out ahead due to the 4700 we got for setting up the portfolio.
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3.21. If the exchange rate is greater than 1.65, it uses its call to buy 100,000 British Pounds for
165,000 Canadian Dollars. If the exchange rate is less than 1.50, the person who bought the put
uses it to sell 100,000 British Pounds to Bright, Light, and Powers for 150,000 Canadian Dollars.
For exchange rates in the middle, both options expire worthless, and Bright, Light, and Powers
pays the current exchange rate to buy 100,000 British Pounds.
Amount
165000
160000
155000
150000
1.4
1.5
1.6
1.7
1.8
rate
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3.23. D. Both Mary and Peter are correct; the prices are not arbitrage-free.
The call option prices do not satisfy their convexity condition:
11 - 6
6 - 3
= 0.5 >
= 0.6.
50 - 40
55 - 50
Mary buys one 40-strike calls; sells three 50-strike calls; lends $1; and buys some 55-strike calls.
55 - 50
=
= 1/3.
55 - 40
Buy of K1 .
Sell 1 of K2 .
Buy 1 - of K3 .
-11
S T 40
S T 40
S T 40
+18
-3(ST 50)
-3(ST 50)
Lend $1
-1
erT
erT
erT
erT
Buy 2 calls
-6
2(ST 55)
erT > 0
erT + ST - 40
erT > 0
Strike 40
Sell 3 calls
Strike 50
Strike 55
Total
The total at time 0 is zero, while in all cases, the total at time T is positive, proving arbitrage.
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3(6 - 8) = -6
3(50 - ST)
Lend $2
Buy 2 calls & sells 2 puts Strike 55
-2
2(-3 + 11) = 16
2erT
2(ST - 55)
Total
0
2erT
The total at time 0 is zero, while the total at time T is positive, proving arbitrage.
Comment: See Table 9.7 in Derivatives Markets by McDonald.
The call option prices do not satisfy their convexity condition:
(11 - 6)/(50 -40) = 0.5, while (6 - 3)/(55 - 50) = 0.6 which is larger.
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40
50
55
Since the point (50, 6) is above the line between (40, 11) and (55, 3), convexity is violated.
In other words, the curve of option premium versus strike price is not concave upwards.
The line between (40, 11) and (55, 3) can be written as a weighted average of 11 and 3:
55 - K
y = 11 + 3 (1 - ), where =
.
55 - 40
At K = K2 = 50, = 1/3 =
K3 - K 2
= , and the height of the line is: (11)(1/3) + (3)(2/3) = 5.67 < 6.
K3 - K 1
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40
50
55
Since the point (50, 8) is below the line between (40, 3) and (55, 11), convexity is satisfied.
In other words, the curve of option premium versus strike price is concave upwards.
Long Buy. Short Sell.
The payoff on Peters combination of positions is always zero; thus its correct price is 0.
Since its price is not 0, there is an opportunity for arbitrage.
Depending on the sign of this price, either we would buy and sell Peters combination of positions,
or we would do the exact opposite of what Peter did.
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3.24. Put in simple terms, an arbitrage opportunity is a situation where we can make a sure profit
with no risk. This is sometimes described as a free lunch.
Put more precisely an arbitrage opportunity means that:
(a) We can start at time 0 with a portfolio which has a net value of zero (implying that we are long in
some assets and short in others).
(b) At some future time T:
the probability of a loss is 0.
the probability that we make a strictly positive profit is greater than 0.
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Adam
$100
Stock
Eve
$100
Stock
Two years from now Adam and Eve have the same position.
Therefore, Adam and Eves initial positions must have the same price.
Call + K e-rT = Put + Stock.
If the stock had paid dividends, then Eve would have collected them, while Adam will not. If we
subtract the present value of these dividends, then their two positions would still be equal.
PV[F0,T] = S0 - PV[Div].
Setting equal the values of Adams position and Eves position minus any dividends we have:
Call + K e-rT = Put + PV[F0,T].
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Value of Call at Time T - Value of Put at Time T = Value of Stock at Time T - Strike Price.
Stocks With Discrete Dividends:
If dividends are paid at discrete times, then PV[F0,T] = S0 - PV[Div].96
C E u r(K, T) = PE u r(K, T) + S0 - PV[Div] - K e-rT.97
Stocks With Continuous Dividends:
If dividends are paid continuously, then PV[F0,T] = S0 e-T.
C E u r(K, T) = PE u r(K, T) + S0 e-T - K e-rT.98
95
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See Example 9.1 in Derivatives Markets by McDonald. When S = K, the option is said to be at the money.
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Bonds:
A bond pays coupons to its owner. These coupon payments act mathematically like stock
dividends paid at discrete times. Therefore, if B0 is the current price of the bond:100
C E u r(K, T) = PE u r(K, T) + B0 - PV[Coupons] - K e-rT.
Summary:
As will be discussed in subsequent sections, there are similar relationships for other assets.
Asset
Parity Relationship
Stock, No Dividends
S 0 = C - P + e-rT K
S 0 - PV[Div] = C - P + e-rT K
e-T S0 = C - P + e-rT K
Bond101
B 0 - PV[Coupons] = C - P + e-rT K.
Futures Contract102
e-rT F0 = C - P + e-rT K
Currency
exp[-rf T] x0 = C - P + e-rT K
Exchange Options
P (S ) = C - P + F P (Q )
F0,T
0
0
0,T
exp[-S T] S0 = C - P + exp[-Q T] Q0
100
While listed by McDonald, he does not discuss further this formula involving bonds.
In this formula, e-rT is the price of a zero-coupon bond that pays 1 at time T.
101
See Table 9.9 of Derivatives Markets by McDonald.
102
Where F0 is the futures price at time zero for the delivery time in the futures contract underlying the options.
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103
Dividend Forward Contract:
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Problems:
4.1 (2 points) Jay Corp. common stock is priced at $80 per share.
The company just paid its $1 quarterly dividend. Continuously compounded Interest rate is 6.0%.
A $75 strike European call, maturing in 8 months, sells for $10.
What is the price of a 8-month, $75 strike European put option?
A. 3
B. 4
C. 5
D. 6
E. 7
4.2 (2 points) A bond currently costs $830. The bond has $10 quarterly coupons.
A coupon has just been paid. r = 4%. What is the difference in price between a 2-year $800 strike
European call option and the corresponding put?
A. 15
B. 20
C. 25
D. 30
E. 35
Use the following information for the next two questions:
The Rich and Fine stock index is priced at 1300. Dividends are paid at the rate of 2%.
The continuously compounded risk free rate is 5%.
4.3 (1 point) A 1800 strike European call, maturing in 4 years, sells for 196.
What is the price of a 4-year, 1800 strike European put option?
A. Less than 400
B. At least 400, but less than 450
C. At least 450, but less than 500
D. At least 500, but less than 550
E. At least 550
4.4 (1 point) A 1500 strike European put, expiring in 3 years, sells for 293.
What is the price of a 3-year, 1500 strike European call option?
A. 150
B. 175
C. 200
D. 225
E. 250
4.5 (2 points) For a stock that does not pay dividends, the difference in price between otherwise
similar European call and put options is 29.05. The current stock price is 100. r = 6%.
The time until expiration is 2 years. Determine the strike price.
A. 80
B. 85
C. 90
D. 95
E. 100
4.6 (2 points) 160 = current market price of the stock
130 = strike price of the option
5% = annual risk free force of interest
18 months = time until the exercise date of the option
3% = (continuously compounded) annual rate at which dividends are paid on this stock
If a European put has an option premium of 13, determine the premium for a similar European call.
A. 35
B. 40
C. 45
D. 50
E. 55
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4.11 (2 points) The price of a non-dividend paying stock is $85 per share. A 18 month, at the
money European put option is trading for $5. If the interest rate is 6.5%, what is the price of a
European call at the same strike and expiration?
A. 12
B. 13
C. 14
D. 15
E. 16
4.12 (2 points) As a function of the future stock price, graph the future value of the sum of a share of
the stock and a European put option on that same stock with a strike price of 100.
4.13 (2 points) A stock that pays continuous dividends at 1.5%, has a price of 130. r = 4%.
At what strike price are a 2 year European put and call worth the same?
A. Less than 126
B. At least 126, but less than 128
C. At least 128, but less than 132
D. At least 132, but less than 136
E. At least 136
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4.14 (2 points) The prices for otherwise similar European puts and calls are:
Strike
100
120
Call premium
27
23
Put premium
25
26
Describe a spread position involving puts and calls that you can use to affect arbitrage, and
demonstrate that arbitrage occurs.
4.15 (2 points) Kay Corp. common stock is priced at $120 per share.
Yesterday, the company paid its $2 quarterly dividend.
The continuously compounded interest rate is 5.0%.
The company just paid its $2 quarterly dividend. Interest rates are 5.0%.
A $130 strike European put, maturing in 4 months, sells for $15.
What is the price of a 4-month, $130 strike European call option?
A. 3
B. 4
C. 5
D. 6
E. 7
4.16 (3 points) You are given the following premiums for European options:
Strike Price Call Price
Put Price
$60
$3.45
$80
$23.85
$9.88
$90
$19.56
$14.38
$110
$13.09
All of the options are on the same stock and have the same expiration date.
Determine the sum of the price of the 60 strike call plus the price of the 110 strike put.
A. 59.0
B. 59.5
C. 60.0
D. 60.5
E. 61.0
4.17 (2 points) Joe buys a share of a stock, buys a European put option on that stock with a strike
price of 100, and sells a European call option on that stock with a strike price of 100. Graph the
future value of Joes investments as a function of the stock price at expiration of the options.
4.18 (2 points) 150 = current market price of the stock
140 = strike price of the option
6% = annual risk free force of interest
6 months = time until the exercise date of the option
3% = (continuously compounded) annual rate at which dividends are paid on this stock
If a European call has an option premium of 23, determine the premium for a similar European put.
A. 7
B. 8
C. 9
D. 10
E. 11
4.19 (2 points) A European put and call on the same stock have the same time until maturity and the
same strike price. S0 = 100. K = 115. r = 6%. = 2%.
If the put and the call have the same premium, what is the time until maturity?
A. 1.5 years
B. 2.0 years
C. 2.5 years
D. 3.0 years
E. 3.5 years
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4.25 (2 points) You are given the following information on European options on a given stock index
that does not pay dividends.
All the options have the same strike price and all expire on July 1, 2008.
As of January 1, 2008
As of March 1, 2008
Stock Index Price
860
1020
Call Premium
66.67
154.64
Put Premium
86.64
21.24
Determine the continuously compounded risk rate of interest, r.
A. 4.5%
B. 5.0%
C. 5.5%
D. 6.0%
E. 6.5%
4.26 (2 points) A stock is priced at $93 per share.
The stock pays dividends at a continuously compounded rate .
r = 5.2%.
The premium for a $90-strike 2-year European call is $18.50.
The premium for a $90-strike 2-year European put is $9.36.
Determine .
A. 0.5%
B. 1.0%
C. 1.5%
D. 2.0%
E. 2.5%
4.27 (3 points) You observe the prices of various European call and put options all on the same
stock and all with the same expiration date:
Strike Price Call Price
Put Price
$60
$21
$6
$70
$17
$11
$90
$12
$25
After reviewing the information above, Andrew tells Brittany and Christopher that no arbitrage
opportunities can arise from these prices.
Brittany disagrees with Andrew. She argues that one could use a portfolio of various calls to obtain
arbitrage profit.
Christopher also disagrees with Andrew. He claims that one could use a portfolio of various puts to
obtain arbitrage profit.
Which of the following statements is true?
(A) Only Andrew is correct.
(B) Only Brittany is correct.
(C) Only Christopher is correct.
(D) Both Brittany and Christopher are correct.
(E) None of them is correct.
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4.33 (3 points)
Consider European options all on the same stock and all with the same time until expiration.
Let C(K) be the premium for a call with strike K.
Let P(K) be the premium for a put with strike K.
Let A(K) = C(K) - C(K + 10).
Let B(K) = P(K + 10) - P(K).
A(95) = 3.49.
B(95) = 5.36.
B(80) = 3.87.
Determine A(80).
A. 4.7
B. 4.8
C. 4.9
D. 5.0
E. 5.1
4.34 (2 points) A stock index pays dividends at a continuously compounded rate of 1%.
The current price of the stock index is $730.
The continuously compounded annual risk-free interest rate is 4%.
The cost of a nine-month 800-strike European call on this stock index is $44.49.
Determine bounds on the cost of a nine-month 790-strike European put on this stock index.
4.35 (2 points) For a dividend paying stock and European options on this stock, you are given the
following information:
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4.36 (CAS5B, 11/92, Q.64) (1 point) For a certain non-dividend paying stock, the price of a put
option with a strike price of $100 exercisable in one year is $25.
The current stock price is $120. The cost to borrow money is 10% for one year.
What is the price of a call with an strike price of $100 exercisable in one year?
A. Less than $50
B. At least $50, but less than $55
C. At least $55, but less than $60
D. At least $60, but less than $65
E. $65 or greater
4.37 (CAS5B, 11/94, Q.29) (4.5 points) An investor would like to sell short ABC company's
stock, currently valued at $100, and will close out this position in one year.
a. (1 point) What does it mean "to sell short ABCs stock"?
b. (1 point) In a graph, depict the cumulative payoff in one year to this investor, relative to ABC's
stock price. Ignore interest and transaction costs. Assume ABC pays no dividends.
For (c) and (d) below, assume the investor does not want to lose more than $100 on this transaction
when she closes out her position at the end of the year. Further assume a European options market
exists for ABC stock. Assume ABC pays no dividends.
c. (1.5 points) Construct an option that would achieve this goal, ignoring the cost of the option itself,
interest charges, and any related transaction costs. Draw two graphs: the first to show the payoff of
this option, and the second to show the investor's net payoff after implementing this strategy.
d. (1 point) Given the following table, what is the expected cost of this "insurance"?
Assume a continuously compounded risk-free interest rate of 10% per year, and ignore transaction
costs and potential broker margin calls.
Term: One Year
Strike Price Value of Put
50
5
75
10
100
15
125
30
150
50
175
72
200
95
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4.38 (CAS5B, 5/99, Q.1) (1 point) You sell a 1-year European call option on Greystokes Inc.
with an strike price of 110 and buy a 1-year European put option with the same strike price and
term. The current continuously compounded risk-free rate is 12% and the value of your combined
position is zero.
Greystokes Inc. is a non-dividend-paying stock. What is the price of a share of Greystokes Inc.?
A. Less than 95.00
B. At least 95.00, but less than 97.50
C. At least 97.50, but less than 100.00
D. At least 100.00, but less than 102.50
E. At least 102.50
4.39 (IOA 109, 9/00, Q.1) (8.25 points)
(i) (1.5 points) State what is meant by put-call parity.
(ii) (4.5 points) Derive an expression for the put-call parity of a European option that has a dividend
payable prior to the exercise date.
(iii) (2.25 points) If the equality in (ii) does not hold, explain how an arbitrageur can make a riskless
profit.
4.40 (MFE Sample Exam, Q.1) Consider a European call option and a European put option on a
nondividend-paying stock. You are given:
(i) The current price of the stock is $60.
(ii) The call option currently sells for $0.15 more than the put option.
(iii) Both the call option and put option will expire in 4 years.
(iv) Both the call option and put option have a strike price of $70.
Calculate the continuously compounded risk-free interest rate.
(A) 0.039
(B) 0.049
(C) 0.059
(D) 0.069
(E) 0.079
4.41 (FM Sample Exam, Q.1) Which statement about zero-cost purchased collars is FALSE?
A. A zero-width, zero-cost collar can be created by setting both the put and call strike prices
at the forward price.
B. There are an infinite number of zero-cost collars.
C. The put option can be at-the-money.
D. The call option can be at-the-money.
E. The strike price on the put option must be at or below the forward price.
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4.42 (FM Sample Exam, Q.2) You are given the following information:
The current price to buy one share of XYZ stock is 500.
The stock does not pay dividends.
The risk-free interest rate, compounded continuously, is 6%.
A European call option on one share of XYZ stock with a strike price of K that expires in
one year costs 66.59.
A European put option on one share of XYZ stock with a strike price of K that expires in
one year costs 18.64.
Using put-call parity, determine the strike price, K.
A. 449
B. 452
C. 480
D. 559
E. 582
4.43 (FM Sample Exam, Q.5) You are given the following information:
One share of the PS index currently sells for 1,000.
The PS index does not pay dividends.
The effective annual risk-free interest rate is 5%.
You want to lock in the ability to buy this index in one year for a price of 1,025. You can do this by
buying or selling European put and call options with a strike price of 1,025.
Which of the following will achieve your objective and also gives the cost today of establishing this
position?
A. Buy the put and sell the call, receive 23.81
B. Buy the put and sell the call, spend 23.81
C. Buy the put and sell the call, no cost
D. Buy the call and sell the put, receive 23.81
E. Buy the call and sell the put, spend 23.81
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4.44 (CAS3, 5/07, Q.3) (2.5 points) For a dividend paying stock and European options on this
stock, you are given the following information:
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4.47 (MFE, 5/07, Q.4) (2.6 points) For a stock, you are given:
(i) The current stock price is $50.00.
(ii) = 0.08
(iii) The continuously compounded risk-free interest rate is r = 0.04.
(iv) The prices for one-year European calls (C) under various strike prices (K) are shown below:
K
C
$40 $ 9.12
$50 $ 4.91
$60 $ 0.71
$70 $ 0.00
You own four special put options each with one of the strike prices listed in (iv).
Each of these put options can only be exercised immediately or one year from now.
Determine the lowest strike price for which it is optimal to exercise these special put option(s)
immediately.
(A) $40
(B) $50
(C) $60
(D) $70
(E) It is not optimal to exercise any of these put options.
4.48 (CAS3, 11/07, Q.14) (2.5 points)
Given the following information about a European call option on Stock Z:
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4.49 (CAS3, 11/07, Q.16) (2.5 points) An investor has been quoted a price on European
options on the same non-dividend paying stock. The stock is currently valued at 80 and the
continuously compounded risk-free interest rate is 3%. The details of the options are:
Option 1
Option 2
Type
Put
Call
Strike
82
82
Time to expiration 180 days
180 days
Based on his analysis, the investor has decided that the prices of the two options do not present
any arbitrage opportunities. He decides to buy 100 calls and sell 100 puts.
Calculate the net cost of this transaction.
(Hint: A positive net cost means the investor pays money from the transaction. A negative cost
means the investor receives money.)
A. Less than -60
B. At least -60, but less than -20
C. At least -20, but less than 20
D. At least 20, but less than 60
E. At least 60
4.50 (MFE/3F, 5/09, Q.12) (2.5 points) You are given:
(i) C(K, T) denotes the current price of a K-strike T-year European call option on a
nondividend-paying stock.
(ii) P(K, T) denotes the current price of a K-strike T-year European put option on the same stock.
(iii) S denotes the current price of the stock.
(iv) The continuously compounded risk-free interest rate is r.
Which of the following is (are) correct?
(I) 0 C(50, T) - C(55, T) 5e-rT
(II) 50e-rT P(45, T) - C(50, T) + S 55e-rT
(III) 45e-rT P(45, T) - C(50, T) + S 50e-rT
(A) (I) only
(B) (II) only
(C) (III) only
(D) (I) and (II) only
(E) (I) and (III) only
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4.51 (CAS8, 5/10, Q.16) (4 points) Given the following stock option information:
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Solutions to Problems:
4.1. B. CEur(K, T) = PEur(K, T) + S0 - PV[Div] - K e-rT.
10 = P + 80 - {(1)e-0.015 + (1)e-0.03} - (75)e-0.04. P = $4.01.
Comment: We only include dividends from when the option is bought to when it expires;
we do not include the dividend that was just paid.
4.2. A. CEur(K, T) = PEur(K, T) + B0 - PV[Coupons] - K e-rT.
C-P=
830 - (10)(e-0.01 + e-0.02 + e-0.03 + e-0.04 + e-0.05 + e-0.06 + e-0.07 + e-0.08) - (800)e-0.08 =
$15.01.
4.3. C. CEur(K, T) = PEur(K, T) + S0 e-T - K e-rT.
196 = P + 1300e-0.08 - 1800e-0.2. P = 469.66.
4.4. D. CEur(K, T) = PEur(K, T) + S0 e-T - K e-rT.
C = 293 + 1300e-0.06 - 1500e-0.15 = 226.23.
4.5. A. With no dividends, = 0 and: CEur(K, T) - PEur(K, T) = S0 - K e-rT.
29.05 = 100 - K e-0.12. K = 80.00.
4.6. C. CEur(K, T) = PEur(K, T) + S0 e-T - K e-rT = 13 + (160)e-(0.03)(1.5) - (130)e-(0.05)(1.5) =
45.35.
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4.7. & 4.8. Sell the call for $13.00. Buy the put at $3.20.
We buy a share of stock for $169.70.
Borrowing the present value of the $160 strike price we receive:
160 exp[-(2%)(3.25/12)] = $159.136.
Borrowing the present value of the $0.36 dividend we receive:
0.36 exp[-(2%)(1/12)] = $0.359.
The cost of our position is: 3.20 - 13.00 + 169.70 - 159.136 - 0.359 = $0.405.
So we need to come up with a positive amount of money in order to set up this position.
We get the dividend of $0.36 in one month and repay the lender.
At expiration if ST > K, then the person to whom we sold the call will exercise it and buy our share of
HAL for K. We will then pay K to the lender. If instead ST K, then we sell our share of HAL for K to
the person from whom we bought the put. We will then pay K to the lender.
In either case, we end up with nothing at time T.
We needed to come up with a positive amount of money in order to set up a position which turns
out to be worth nothing.
Thus this is not a case of arbitrage.
Put-call parity would have been violated if there was arbitrage available.
Thus parity was not violated.
Comment: Similar to question 9.17 in Derivatives Markets by McDonald.
Beyond what I expect you to be asked on your exam.
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4.9. & 4.10. Buy the call for $13.40. Sell the put at $2.90.
We borrow a share of stock, sell it for $169.70, and will give this person a share of stock in 3.25
months when the option expires. We also must pay this person the stock dividend they would
have gotten on the stock, when they would have gotten it.
Lending the present value of the $160 strike price we receive:
160 exp[-(1.9%)(3.25/12)] = $159.179.
Lending the present value of the $0.36 dividend we receive: .36 exp[-(1.9%)(1/12)] = $0.359.
The cost of our position is: 13.40 - 2.90 - 169.70 + 159.179 + 0.359 = $0.338.
So we need to come up with a positive amount of money in order to set up this position.
We will receive from the person to whom we made the loan the money to pay the stock dividend to
the person from whom we borrowed the stock. We will receive from the person to whom we made
the loan the strike price at expiration of the options 3.25 months from now. If ST K, then we
exercise our call and buy a share of HAL for K, and give the share to the person from whom we
borrowed the stock. If instead ST < K, then we buy a share of HAL for K from the person who
exercises the put option we sold, and give the share to the person from whom we borrowed the
stock. In either case, we end up with nothing at time T.
We needed to come up with a positive amount of money in order to set up a position which turns
out to be worth nothing.
Thus this is not a case of arbitrage.
Put-call parity would have been violated if there was arbitrage available.
Thus parity was not violated.
4.11. B. With no dividends, = 0. At the money means: K = S0 = 85.
C Eur(K, T) = PEur(K, T) + S0 e-T - K e-rT = 5 + 85 - 85e-(1.5)(0.065) = 12.90.
Comment: For a non-dividend paying stock the difference between similar at the money options is:
C Eur(K, T) - PEur(K, T) = S0 (1 - e-RT).
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4.12. Graph of the future value of a share of the stock plus a European put with a strike price of
S+100 S = 100, for S < 100
100, S + E[(100 - S)+] =
= Max[S, 100]:
S + 0 = S, for S 100
Option Value
240
220
200
180
160
140
120
100
50
100
150
200
Stock Price
250
Comment: If today one buys a share of the stock plus a put option to sell the stock at 100, then at
the expiration of the option, you can sell the stock for 100 (by exercising the put option) or the
market price of the stock, whichever is higher.
4.13. E. 0 = CEur(K, T) - PEur(K, T) = S0 e-T - K e-rT.
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4.14. Buy a call with strike 100: cost 27. Sell a put with strike 100: get 25.
Sell a call with strike 120: get 23. Buy a put with strike 120:cost 26.
Cost is: 27 + 26 - 25 - 23 = 5.
We borrow 5 at the risk free rate.
The payoff on the options is: (ST - 100)+ - (100 - ST)+ - {(ST - 120)+ - (120 - ST)+} =
S T - 100 - (ST - 120) = 20.
For any reasonable values of r and T, 5erT < 20.
After repaying the loan, we have: 20 - 5erT > 0.
Thus for no investment, we end up with a position whose value is always positive.
Comment: Similar to Q. 9.8 in Derivatives Markets by McDonald.
The given call premiums are OK by themselves. The given put premiums are OK by themselves.
The given 100 strike premiums are OK by themselves.
The given 120 strike premiums are OK by themselves.
The arbitrage results from the relationship between all of the given premiums.
By put-call parity, C - P = PV[F0,T] - PV[K].
For the 100 strike options: 2 = PV[F0,T] - 100e-rT.
For the 120 strike options: -3 = PV[F0,T] - 120e-rT.
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50
100
150
200
250
Stock Price
Comment: If today you buy a share of the stock plus a put option to sell the stock at 100, and also
sell to Fred a call option with a strike price of 100, then at the expiration of the options:
(a) If the future stock price is below 100, you can sell the stock for 100 by exercising the put option.
Fred has no interest in exercising his call option and buying your share of the stock for 100, since 100
is higher than the market price of the stock.
(b) If the future stock price is above 100, Fred will exercise his call option to buy your share of the
stock for 100, which is lower than the market price of the stock.
In either case (a) or (b), you end up with 100.
By buying a share, buying a put, and selling a call, you have removed the uncertainty in the future
value of your investment. An example of put-call parity.
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4.24. E. Let us assume the strikes for the Call Bull Spread are K and K + 10.
Call Bull Spread: Buy a K strike call and sell a K + 10 strike call.
Premium for Call Bull Spread is: C(K) - C(K+10) = 4.19.
Put Bear Spread: Sell a K strike put and buy a K + 10 strike put.
By put-call parity: P(K) = C(K) + K e-rT - S0 e-T.
By put-call parity: P(K+10) = C(K+10) + (K+10) e-rT - S0 e-T.
Premium for the Put Bear Spread is:
P(K+10) - P(K) = C(K+10) - C(K) + 10e-rT = 10e-(0.056)(2) - 4.19 = 4.75.
Comment: Premium for the Put Bull Spread is -4.75.
Bull Spread: The purchase of an option together with the sale of an otherwise identical option with a
higher strike price. One can construct a bull spread using either puts or calls.
Bear Spread: The sale of an option together with the purchase of an otherwise identical option with a
higher strike price. One can construct a bear spread using either puts or calls.
4.25. A. Applying put call parity on January 1:
66.67 = 86.64 + 860 - Ke-r/2. Ke-r/2 = 879.97.
Applying put call parity on March 1:
154.64 = 21.24 + 1020 - Ke-r/3. Ke-r/3 = 886.60.
Therefore dividing the two equations, er/6 = 886.60/879.97 = 1.00753. r = 0.045.
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Combining the first two equations: 60 e-rT + 21 - 6 = 70 e-rT + 17 - 11. e-rT = 0.90.
Combining the last two equations: 70 e-rT + 17 - 11 = 90 e-rT + 12 - 25. e-rT = 0.95.
Thus the sets of prices for the puts and calls are not consistent.
Thus one could use a portfolio of puts and calls to obtain arbitrage profit.
Comment: Similar to MFE Sample Exam, Q.2.
A graph of the call premiums:
C
21
17
12
60
70
90
11
6
60
70
90
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One can demonstrate arbitrage by: buying two 60-strike calls, selling two 60-strike puts,
selling three 70-strike calls, buying three 70-strike puts,
buying one 90-strike call, and selling one 90-strike put.
You get in the door initially for setting up this portfolio:
(2)(6) - (2)(21) + (3)(17) - (3)(11) + (1)(25) - (1)(12) = 1.
We invest this 1 at the risk free rate, and on the expiration date of the options we have erT.
If ST < 60, all of the calls turn out to be worthless, and the payoffs from the puts are:
-(2)(60 - S) + (3)(70 - S) - (1)(90 - S) = 0.
If 60 ST < 70, then the payoffs from the options are:
(2)(S - 60) + (3)(70 - S) - (1)(90 - S) = 0.
If 70 ST < 90, then the payoffs from the options are:
(2)(S - 60) - (3)(S - 70) - (1)(90 - S) = 0.
If 90 ST, then the puts are all worthless and the payoffs from the calls are:
(2)(S - 60) - (3)(S - 70) + (1)(S - 90) = 0.
So regardless, the payoffs are zero, and we end up with erT, demonstrating arbitrage.
(S - K)+ - (K - S)+ = S - K.
Thus the payoff from buying a call and selling the similar put is: S - K.
Thus the payoff for this portfolio of puts and calls is: 2 (ST - 60) - 3 (ST - 70) + (ST - 90) = 0.
4.28. Let C(80) be the premium of the 80-strike call.
By put-call parity, C(80) = 8.61 + 76 - 80 e-2r = 84.61 - 80 e-2r.
This is positive.
The various properties of call premiums must hold.
7.93 < C(80) < 19.77. 7.93 < 84.61 - 80 e-2r < 19.77. 64.84 < 80 e-2r < 76.68.
19.77 - C(80) = 6.11 < 8.87 = 10 e-2r. C(80) - 7.93 = 5.73 < 17.74 = 20 e-2r.
Thus all three properties of call premiums would hold.
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80
= 17.11.
1.13
Comment: Assume Adam bought a three year call and loaned out
80
.
1.13
Then at time 3, Adam can use 80 to exercise his call if it makes sense to do so.
Assume Eve bought a three year put and a three-year prepaid forward contract on the stock.
Then at time 3, Eve could use her put to sell the stock for 80 if it makes sense to do so.
Then if S2 > 80, both Adam and Eve end up with the stock.
Then if S2 < 80, both Adam and Eve end up with 80.
Therefore, Call +
80
= Put + S0 e-3. A form of put-call parity.
1.13
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4.35. E. Based on put-call parity, we would expect the call to have a price of:
P - Ke-rT + Se-T = 5.00 - 60 e-(0.04)(3/4) + 57 e-(0.01)(3/4) = $3.35.
Therefore, the call is overpriced at $3.80.
The present value arbitrage profit is: $3.80 - $3.35 = $0.45.
Alternately, based on put-call parity, we would expect the put to have a price of:
C + Ke-rT - Se-T = 3.80 + 60 e-(0.04)(3/4) - 57 e-(0.01)(3/4) = $5.45.
Therefore, the put is underpriced at $5.00.
The present value arbitrage profit is: $5.45 - $5.00 = $0.45.
Comment: We can take advantage of the arbitrage by:
buying a put, selling a call, and buying e-T = e-(0.01)(3/4) = 0.9925 shares of stock.
When we set up the position we receive: 3.80 - 5.00 - 57 e-(0.01)(3/4) = -57.774.
We borrow this at the risk free rate, and will need to repay 57.774 e(0.04)(3/4) = 59.533, at time 3/4.
At time 3/4 we have 1 share of stock.
If S3/4 < K = 60, then we use our put to sell our share of stock for 60.
If S3/4 > K = 60, then the person to whom we sold the call uses it to buy our share of stock for 60.
In either case, after repaying our loan are left with: 60 - 59.533 = $0.467.
The present value is: 0.467 e-(0.04)(3/4) = $0.45.
Comment: Similar to CAS3, 5/07, Q.3.
4.36. B. C = P + S - K e-rt = 25 + 120 - 100 e-0.1 = $54.52.
Comment: If instead you assume the 10% is an effective annual rate, then:
C = P + S - K e-rt = 25 + 120 - 100/1.1 = $54.09.
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4.37. a. One borrows shares of ABC stock from someone who owns them, and then sell the
shares. You promise to return the shares of stock in the future, in this case in one year, along with the
present value of any dividends issued on the stock.
b. Assuming ABC stock pays no dividends, then one year from now the investor will have to buy a
share of ABC stock with price S1 ; ignoring interest the payoff is: 100 - S1 .
Payoff
100
50
50
100
150
200
250
- 50
- 100
- 150
c. Buying a one-year 200-strike European call would limit her lose to $100. The payoff on the call:
Payoff
50
40
30
20
10
50
100
150
200
250
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50
50
100
150
200
250
- 50
- 100
d. Assuming no dividends, C = P + S - Ke-rT = 95 + 100 - 200 e-0.1 = 14.03.
4.38. C. C = P + Se-T - Ke-rT. Since C = P and = 0, S = Ke-rT = 100e-0.12 = 97.56.
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4.39. (i) Put-call parity expresses a relationship between the price of a put option and the price of a
call option on a stock where the options have the same exercise dates and strike prices.
(ii) Consider a portfolio A which contains one European call and an amount of cash D + Xe-r(T-t),
where X = exercise price, r = risk-free rate, T - t = time to exercise of the option,
D = present value of dividends payable.
At the exercise date if the share price ST X then the call will be exercised and portfolio A will have
a value of D er(T-t) + ST.
If at T we have ST < X then the call will not be exercised and portfolio A will be worth D er(T-t) + X.
Now consider portfolio B consisting of one European put and a share. At the exercise date if ST X
then the put will not be exercised and portfolio B will have value of ST + D er(T-t).
If at the exercise date T, we have ST < X then the put will be exercised and portfolio B will have a
value of X + D er(T-t).
Portfolios A and B have the same value in all circumstances at the exercise date T.
Hence they must be equivalent at all earlier times. the portfolios are of equal value.
Therefore c + D + Xe-r(T-t) = p + St. c = value of European call with strike X and exercise date T.
p = value of European put with strike X and exercise date T. St = value of stock at time t.
(iii) Let D be the present value of dividends payable and consider: c + D + X e-r(T-t) < p + St.
Then for some amount A: A + c + D + X e-r(T-t) = p + St.
Hence we can short one share and sell a put and receive p + St
At the exercise date we know the value of this portfolio is: max[ST + D er(T-t), X + D er(T-t)].
However we know that the value of a portfolio invested in a European call and D + Xe-r(T-t) at time t
will be worth max[ST + D er(T-t), X + D er(T-t)] at time T.
This is the same as the amount we must repay at time T.
Hence we are left with a profit of Aer(T-t).
Therefore, the strategy in order to make a riskless profit is short 1 share and sell a put, buy 1 call and
put on deposit A + D + X e-r(T-t).
The net investment is zero at time t, and we end up with Aer(T-t) at time T.
If the inequality is reversed also reverse investment (i.e. swap long positions for short positions and
vice versa).
4.40. A. The put-call parity formula for a European call and a European put on a
nondividend-paying stock with the same strike price and maturity date is: C - P = S0 - Ke-rT.
0.15 = 60 - 70e-r4. r = 0.039.
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4.41. D. By put call parity, C - P = S - PV[Div] - Ke-rT. For at the money options, S = K, and C - P
= K - PV[Div] - Ke-rt. Assuming the dividend rate is less than r, C - P < 0. Therefore, the premium of
the at-the-money put is less than the premium of the at-the-money call.
Therefore, if the call is at-the-money, the put option with the same cost will have a higher strike price.
However, a purchased collar requires that the put have a lower strike price.
Thus statement D is false.
Comment: On the syllabus of an earlier exam; beyond the level of detail you are likely need for
your exam. A collar is the purchase of a put option and the sale of a similar call with a higher strike;
both options are on the same stock and have the same expiration date. If the collar is written rather
than purchased, then the put is sold and the call is bought. In the case of a zero-cost collar, the two
option premiums are the same, and the net cost of the collar is zero.
4.42. C. For no dividends, by put call parity: C - P = S - Ke-rT.
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4.44. B. Based on put-call parity, we would expect the call to have a price of:
P - Ke-rT + Se-T = 2.35 - 50 e-0.03/2 + 49.70 e-0.02/2 = $2.30.
Therefore, the call is underpriced at $2.00.
The present value arbitrage profit is: $2.30 - $2.00 = $0.30.
Alternately, based on put-call parity, we would expect the put to have a price of:
C + Ke-rT - Se-T = 2.00 + 50 e-0.03/2 - 49.70 e-0.02/2 = $2.05.
Therefore, the put is overpriced at $2.35.
The present value arbitrage profit is: $2.35 - $2.05 = $0.30.
Comment: We can take advantage of the arbitrage by:
buying a call, selling a put, and shorting e-T = e-0.02/2 = 0.990 shares of stock.
(We borrow 0.990 shares of stock from someone at time 0 and return 1 share of stock at time 1/2.
If one owned 0.990 shares and reinvested the dividends, one would have 0.990e0.02/2 = 1 share
at time 1/2.)
When we set up the position we receive: 2.35 - 2.00 + (49.70)e-0.02/2 = 49.556.
We invest this at the risk free rate, and end up with 49.556 e0.03/2 = 50.305, at time 1/2.
At time 1/2 we need 1 share of stock to return to the person we borrowed it from.
If S1/2 > K = 50, then we use our call to buy a share of stock at 50.
If S1/2 < K = 50, then the person to whom we sold the put uses it to sell us a share of stock at 50.
In either case, we use $50 to buy a share of stock, and are left with $50.305 - $50 = $0.305.
The present value is: $0.305 e-0.03/2 = $0.30.
Put another way, one can buy a synthetic put by:
buying a call, lending at the risk free rate K e-rT, and shorting e-T = e-0.02/2 shares of stock.
The cost of this synthetic put is: 2.00 + 50 e-0.03/2 - 49.70 e-0.02/2 = $2.05.
We can sell an actual put for $2.35 and buy the synthetic put for $2.05, making $0.30.
4.45. E. Based on put-call parity,
P = C + Ke-rT - (S - PV[Dividends]) = 2 + 30 e-0.10/2 - {29 - 0.50e-0.10/6 - 0.50e-0.10(5/12)} =
$2.51.
4.46. B. By put-call parity, C = P + S - PV[Div] - K e-rT. Let x be the size of each dividend.
4.50 = 2.45 + 52 - x{e-(0.06)(2/12) + e-(0.06)(5/12)} - (50)e-(0.06)(6/12). x = 0.726.
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Immediate Payoff
Exercise Immediately
$40
$50
$60
$70
$9.12
$4.91
$0.71
$0.00
$0
$0
$10
$20
$1.40
$6.79
$12.20
$21.10
No
No
No
No
We exercise immediately if the payoff for the put, (K - 50)+, is more than the premium for a
European Put. That is not the case for any of the four examples here.
Comment: The present value of an option if one does not exercise it, is called the continuation value.
American options can be exercised any time up through expiration. Thus unlike here, one would
need to compare the payoff and the continuation value at more times than just initially, in order to
decide whether it is optimal to exercise early.
4.48. D. P = C + PV[K] + PV[Div] - S = 5.50 + 47 e-(2)(0.05) + 1.5 e-0.05 - 45 = 4.45.
Alternately, the prepaid forward price for the stock is: 45 - 1.5 e-0.05 = 43.57.
P = 5.50 + 47 e-(2)(0.05) - 43.57 = 4.46.
4.49. A. C - P = S - K exp[-rT] = 80 - 82 e-(0.03)(1/2) = -0.7792.
100(C - P) = -77.92.
Comment: Since the call is worth less than the put, the investor receives money.
4.50. E. A 55 strike call is worth less than a 50 strike call, so 0 C(50, T) - C(55, T).
The difference in payoffs between a 50 strike and 55 strike call is at most 5.
Since these are European options, these payoffs takes place T years in the future.
Therefore, C(50, T) - C(55, T) 5e-rT. Statement I is true.
By put-call parity, P(45, T) = C(45, T) + 45e-rT - S.
Therefore, P(45, T) - C(50, T) + S = C(45, T) - C(50, T) + 45e-rT.
However, 0 C(45, T) - C(50, T) 5e-rT. 45e-rT C(45, T) - C(50, T) + 45e-rT 50e-rT.
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4.51. (a) Using put-call parity, the price of the call should be:
2 + 60 - 2e-0.03/4 - 57 e-0.03/2 = $3.86.
Thus the call is underpriced at $3.
Alternately, using put-call parity, the price of the put should be:
2 + 57 e-0.03/2 - (60 - 2e-0.03/4) = $1.14.
Thus the put is overpriced at $2.
(b) We can buy the call and sell a synthetic call.
To sell the synthetic call, we sell a put, short sell a share of stock, lend 2e-0.03/4 the present value of
dividends, and lend the strike price for 6 months.
We net $0.86 from setting up this position.
In six months, if the stock price is greater than the strike price of $57, we use the call to buy the stock
for $57, repay the stock and accumulated value of dividends to the person from whom we
borrowed the stock.
We are left with $0.86 accumulated for 6 months of interest.
In six months, if the stock price is less than the strike price of $57, then the person to whom we sold
the put uses it to sell us a share of stock for $57; we repay the stock and accumulated value of
dividends to the person from whom we borrowed the stock.
We are left with $0.86 accumulated for 6 months of interest.
4.52. Consider two portfolios.
Portfolio B: buying a fraction exp[-(T - t)] of the underlying asset for St exp[-(T - t)]
and borrowing K exp[-r(T - t)] at time t.
Its value at time t is then St exp[-(T - t)] - K exp[-r(T - t)].
Its value at maturity is then ST - K by taking into account the dividends which are paid
continuously at rate .
Using the absence of arbitrage opportunity, both portfolios should have the same value at any
intermediate time, in particular at time t. Hence:
C t - Pt = St exp[-(T - t)] - K exp[-r(T - t)].
Comment: There are other sets of two portfolios of equal value one could set up in order to prove
put-call parity. For example:
Portfolio A: At time t, buying a call option and lending K exp[-r(T - t)].
Portfolio B: At time t, buying the put option and buying exp[-(T - t)] shares of stock.
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This is more valuable than the option to buy a share of stock at time T in the future.
For example, Tim pays Howard the prepaid forward price for a share of ABC stock and in exchange
Howard agrees to give Tim a share of ABC stock two years from now. By paying this amount of
money today, Tim will own a share of ABC stock two years from now. Instead, Tim could buy a two
year $100 strike call on ABC stock from John. Two years from now Tim will have the option to pay
$100 to buy a share of ABC stock from John.
Owning a share of stock two years from now is more valuable than having the option to buy a share
of stock two years from now for $100. The future value of the former is S2 . The future value of the
latter is: (S2 - 100)+ <S2 .
P (S ) C
107
Therefore, a somewhat more stringent inequality holds: F0,T
0
Eur(S0 , K, T).
106
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Phyllis can buy a forward contract to buy a share of stock at T in the future.
At time T in the future Phyllis will pay F0,T for a share of stock.
Harry can instead buy a call option for this same stock at time T in the future, for a price of
C(S0 , K, T), and can in addition invest PV0,T[K] in a risk-free investment. At time T Harry will then
have the money to buy a share of stock if he chooses to exercise his option.
Phyllis will own a share of stock at time T. Harry can choose to own a share of stock at time T if it is
advantageous to him to exercise his option. Therefore, Harrys position is worth more than Phylliss.
C(S0 , K, T) + PV0,T[K] PV0,T[F0,T]. C(S0 , K, T) PV0,T[F0,T] - PV0,T[K].108
Therefore, recalling that an option can never have a negative value:
S 0 C(S0 , K, T) (PV0 , T[F0 , T] - PV0 , T[K])+ .109
However, PV0,T[F0,T] = S0 - PV[Div]. Therefore, C(S0 , K, T) (S0 - PV[Div] - PV0,T[K])+.
Exercise: K = 100, T = 2, r = 6%, and = 2%.
What are the bounds on the call premium as a function of S0 ?
[Solution: PV0,T[F0,T] - PV0,T[K] = S0 e-T - K e-rT = S0 e-0.04 - 100 e-0.12 = 0.961 S0 - 88.69.
S 0 C(S0 , K, T) (0.961 S0 - 88.69)+.
Comment: 0.961 S0 - 88.69 = 0, for S0 = 92.3 = Ke-(r-)T.]
For these inputs, here is a graph of the possible call premiums as a function of S0 :
C
140
120
100
80
60
40
20
50
108
109
92.3
150
S0
C PV[F0,T] - PV[K].
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50
97.5
150
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60
40
20
50
71
150
S0
P PV[K] - PV[F0,T].
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For these inputs, here is a graph of the possible put premiums as a function of K:
P
140
120
100
80
60
40
20
50
78.9
150
For a European put, the most you can be paid is K at time T, which has present value Ke-rT.
Therefore, Ke-rT P(S0 , K, T).113
Relationship to Put-Call Parity:
From Put-Call Parity, we have:
C Eur(K, T) = PEur(K, T) + PV[F0,T] - PV[K].
Since, PEur(K, T) 0, CEur(K, T) PV[F0,T] - PV[K], as discussed previously.
Since, CEur(K, T) 0, PEur(K, T) + PV[F0,T] - PV[K] 0.
Therefore, PEur(K, T) PV[K] - PV[F0,T], as discussed previously.
113
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Exercise: For a stock that does not pay dividends, demonstrate that when the strike price grows at
the risk free rate, the premium of a European call increases with time to expiration.
[Solution: KT = KerT. Take two similar calls, with different times to expiration T < U.
Assume the premium of the first call with less time to expiration is more than that of the second call.
Buy the U-year call and sell the T-year call
Since we have assumed that the premium of the T-year call is greater than the premium of the
U-year call, we get money in the door, which we invest at the risk-free rate.
If ST KerT then we do not pay off on the T-year call we sold.
We have money plus the T-year call; our position is positive.
If ST > KerT then we pay off on the T-year call: ST - KerT.
However, the premium of the call we own with strike KerU, that has U - T until expiration, is greater
than or equal to: (PV[Forward contract on the stock] - PV[K])+ = (ST - e-r(U-T) KerT)+
= ST - e-r(U-T) KerU = ST - KerT.
Thus the call we still own is worth at least as much as the amount we pay off on the call we sold.
Thus we have at least the money we invested at time 0, plus the interest we earned on it;
your position is positive. Demonstrating arbitrage.]
118
See page 299 of Derivatives Markets by McDonald. See also page 603, to be discussed subsequently.
When there are no dividends. If there are dividends, we would instead have the strike increase at the rate r - ;
after taking into account the dividends we receive, we would earn at least the risk free rate.
119
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Problems:
5.1 (1 point) A European 140 strike 2 year call is an option on a stock with current price 100 and
forward price of 108. r = 5%.
Which of the following intervals represents the range of possible prices of this option?
A. [0, 100] B. [0, 108] C. [9.05, 100]
D. [9.05, 108]
E. [8, 108]
5.2 (1 point) A European 140 strike 2 year put is an option on a stock with current price 100 and
forward price of 108. r = 5%.
Determine the range of possible prices of this option.
5.3 (3 points) One has a European option on a stock with current market price of 100.
The time until expiration is 2 years. r = 5%.
The two year forward price of the stock is 110.
Which the following statements are true?
A. The premium of a call option with a strike price of 80 could not be 80.
B. The premium of a put option with a strike price of 140 could not be 105.
C. The premium of a call option with a strike price of 80 could not be 25.
D. The premium of a put option with a strike price of 140 could not be 30.
E. The premium of an at-the-money put must be at least the premium of an at-the-money call.
5.4 (1 point) A European 110 strike 2 year put is an option on a stock with current price 100 and
forward price of 108. r = 5%.
Which of the following intervals represents the range of possible prices of this option?
A. [0, 100]
B. [0, 110]
C. [1.81, 108]
D. [1.81, 110]
E. [2, 108]
5.5 (1 point) A European 105 strike 2 year call is an option on a stock with current price 100 and
forward price of 108. r = 5%.
Which of the following intervals represents the range of possible prices of this option?
A. [0, 100]
B. [0, 108]
C. [2.72, 100]
D. [2.72, 108]
E. [8, 108]
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140
80
120
60
100
40
80
60
40
20
A.
25
50
75
S0
100 125 150
20
B.
25
50
75
S0
100 125 150
25
50
75
S0
100 125 150
P
120
80
100
60
80
40
60
40
20
C.
25
50
75
25
50
75
S0
100 125 150
P
80
60
40
20
E.
S0
100 125 150
20
D.
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5.7 (2 points) XYZ stock pays dividends at a continuously compounded rate of 2%.
XYZ stock has a current price of 80. r = 10%.
For a 3 year European call on XYZ Stock, which of the following graphs represents the bounds on
the call premium as a function of K?
C
80
C
140
60
120
100
40
80
20
60
40
A.
25
50
75
K
100 125 150
25
50
75
K
100 125 150
75
K
100 125 150
C.
20
B.
70
70
60
50
40
60
30
20
10
30
50
40
20
25
50
75
K
100 125 150
25
50
75
K
100 125 150
10
D.
25
50
C
80
60
40
20
E.
5.8 (CAS5B, 11/94, Q.29) (1 point): Explain why the price of a European call option approaches
the prepaid forward price of the underlying stock less the present value of the strike price as the
stock rises further and further beyond the strike price.
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Solutions to Problems:
5.1. A. S0 C(S0 , K, T) (PV0,T[F0,T] - PV0,T[K])+.
100 C (108 e-0.1 - 140 e-0.1)+ = 0.
Comment: While McDonald does not mention this in Derivatives Markets, for a European call,
P (S ) = PV [F ] = 108 e-0.1 = 97.72.
C F0,T
0
0,T 0,T
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20
40
60
80
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5.8. As the current stock price increases, the probability that the call will be in the money at
expiration approaches one. The payoff at expiration will be ST - K.
The price for this is: F0P,T [S] - K e-rT.
Comment: Note that if it is positive, F0P,T [S] - K e-rT is the lower bound for the call premium.
As S0 increases, the call premium approaches this lower bound.
For example, for a 2-year 100-strike call, with reasonable other inputs, here is the call premium from
the Black-Scholes formula versus this lower bound, as a function of the initial stock price, S0 :
C
100
80
Black-Scholes
60
40
Lower Bound
20
120
140
160
180
200
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See Equation 5.18 in Derivatives Markets by McDonald, on the syllabus of an earlier exam.
Since the current exchange rates are reciprocals of each other, so are the forward prices.
122
For current exchange rates see for example www.xe.com/ucc/
121
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x0 is the price of the asset euros. S0 is the price of the asset stock.
r$ r.
123
We assume that r$ will usually differ from r. Similarly, each currency will have its own associated interest rate.
See equation 9.4 of Derivatives Markets by McDonald.
This is similar to the parity equation for stocks paying continuous dividends, with r taking the place of .
124
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x0 is the price of the asset dollars. S0 is the price of the asset stock.
r r.
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Exercise: If each of Johanns euro-denominated puts for one dollar with a strike price of 0.7692 euros
has a price of 0.0523 euros, determine the price of Sams dollar denominated one year call for one
euro, with a strike price of $1.30.
[Solution: Johanns position costs (1300)(0.0523) = 68 euros.
Thus each of Sams calls should cost: 68 euros/1000 = 0.068 euros.
At the current exchange rate, this is: (0.068 euros)($1.25/ euro) = $0.085.
Comment: Sams position is worth: (1000)($0.085) = $85.]
In general, in order to replicate the dollar denominated call, one needs to buy K euro denominated
puts. Thus the value of the call is K times the value of the put. In order to put the price of the call in
dollars rather than euros, one must multiply by the current exchange rate x0 .
C $ ( x0 , K, T) = x0 K Pf (1/x0 , 1/K, T).125
Exercise: Use the above formula to solve the previous exercise.
[Solution: C$ (1.25, 1.3, T) = (1.25) (1.3) P (1/1.25, 1/1.3, T) = (1.25)(1.3)(0.0523) = $0.085.]
Calls from Sams point of view was equivalent to puts from Johanns point of view.
A call from one point of view is a put from an opposite point of view.
Similarly, P$ ( x0 , K, T) = x0 K Cf (1/x0 , 1/K, T).
For a dollar denominated call, we have the option to use dollars to receive another currency.
For a dollar denominated put, we have the option to receive dollars by using another currency.
For a Euro denominated call, we have the option to use Euros to receive another currency.
For a Euro denominated put, we have the option to receive Euros by using another currency.
125
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126
For example, the current exchange rate could be $0.8 per Euro.
For example, if one could pay 0.10 Euros to purchase the dollar denominated call on Euros, and the current
exchange rate were $0.8 per Euro, then one could also pay 0.10/0.8 = $0.125 to purchase this call.
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Equivalently, Aidan could buy 600,000 dollar denominated 3 month $0.1 European put options to sell pesos.
Then on March 31, if the exchange rate is more than 10 peso per dollar, in other words less than $0.1 per peso, he
can exercise his option and sell the 600,000 Pesos he is paid by Seguros Popular for $60,000.
129
As will be discussed subsequently, such a call could be priced using the Black-Scholes formula. If = 12%, the
interest rate in pesos is 6%, and the interest rate in dollars is 5%, then the premium of each such call would be about
0.25 pesos. Thus 60,000 such calls would cost Aidan about 15,000 pesos on January 1, the equivalent of $1500.
130
Each such put would cost about 0.224 pesos, and Aidan would receive about $1460. Thus if Aidan both buys
the calls and sells the puts, then for a net cost of about $1500 - $1460 = $40, he would be unaffected by changes in
currency exchange rates. In this case, the calls cost more than the puts, since I have assumed the interest rate in
pesos is greater than the interest rate in dollars.
131
For example, if the exchange rate on March 31 were 8 pesos per U.S. dollar, obtaining 600,000 pesos would
normally cost 600,000/8 = $75,000. Using the options bought from Aidan, this person could instead obtain
600,000 pesos for only $60,000.
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Since Aidan will be doing all the work at his office in the United States, he would prefer to be paid in
dollars. If Seguros Popular agrees to pay Aidan $60,000 on March 31, then Seguros Popular rather
than Aidan would face a risk of the exchange rate changing. In this case, if on March 31 the exchange
rate were 12 pesos per U.S. dollar, then Seguros Popular would have to use: (12)(60000) =
720,000 pesos in order to pay $60,000 to Aidan.
Similar to the previous situation, Seguros Popular would have the choice of just accepting this risk, or
buying an option to hedge this risk. Seguros Popular could buy 60,000 peso denominated 3 month
10 peso European call options to buy dollars.132 Then on March 31, if the exchange rate is more
than 10 peso per dollar, Seguros Popular can exercise its options and use the 600,000 Pesos to
buy $60,000, with which to pay Aidan. If on March 31 the exchange rate is less than 10 peso per
dollar, then Seguros Popular would benefit from the exchange rate movement; they would need to
use less than 600,000 pesos in order to pay Aidan $60,000.
In another example, Rosetta Stone is a Mexican pension actuary. On January 1, Rosetta takes a six
month assignment consulting for the Grate American Cheese Company, which is based in the
United States. Rosetta will be paid a lump sum for her work on June 30 at the completion of her
assignment. Rosetta will be doing all the work at her office in Mexico.
The exchange rate on January 1 is 10 pesos per U.S. dollar, or $0.10 U.S. per Mexican Peso.
Exercise: Grate American Cheese Company has agreed to pay Rosetta $100,000. Briefly
discuss the currency exchange risk faced by Rosetta and how she can hedge it using options.
[Solution: If the exchange rate is less than 10 pesos per dollar, then the $100,000 Rosetta will be
paid is worth less than the 1 million pesos she expected. Rosetta could buy 100,000 peso
denominated 6 month 10 peso-strike European put options to sell dollars. Alternately, Rosetta
could buy 1 million dollar denominated 6 month $0.1-strike European call options to buy pesos.]
Exercise: Grate American Cheese Company has agreed to pay Rosetta 1 million pesos. Briefly
discuss the currency exchange risk faced by the company and how to hedge it using options.
[Solution: If the exchange rate is less than 10 pesos per dollar, then the 1 million pesos Rosetta will
be paid will cost the company more than the $100,000 it expected. The company could buy 1
million dollar denominated 6 month $0.1-strike peso European call options to buy pesos.
Alternately, it could buy 100,000 peso denominated 6 month 10 peso-strike European put options
to sell dollars.
Comment: In this and the previous exercise, Rosetta and the company each face the same risk, and
can hedge that risk the same way. If the company had agreed to pay Rosetta $50,000 and
500,000 pesos, then Rosetta and the company would share the currency exchange risk.]
132
Equivalently, Popular could buy 600,000 dollar denominated 3 month $0.1 European put options to sell pesos.
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Problems:
6.1 (2 points) The spot exchange rate of dollars per euro is 1.1.
Dollar and euro interest rates are 5.0% and 6.0%, respectively.
The price of a $0.93 strike 18-month call option is $0.28.
What is the price of a similar put?
A. Less than $0.05
B. At least $0.05, but less than $0.10
C. At least $0.10, but less than $0.15
D. At least $0.15, but less than $0.20
E. At least $0.20
6.2 (2 points) Currently one can buy one dollar for 120 yen.
Dollar and yen interest rates are 4.5% and 3.0%, respectively.
The price of a 100 yen strike 2 year put option is 13 yen.
What is the price in yen of a similar call?
A. Less than 15
B. At least 15, but less than 20
C. At least 20, but less than 25
D. At least 25, but less than 30
E. At least 30
6.3 (2 points) Currently one can buy one Swiss Franc for 0.40 British Pounds (0.4).
The interest rate for Swiss Francs is 5%.
The interest rate for British Pounds is 3%.
The price of a 0.5 strike 3 year call option is 0.05.
Determine the price in Swiss Francs of a 2 Swiss Franc strike 3 year put option.
A. 0.04
B. 0.05
C. 0.10
D. 0.125
E. 0.25
6.4 (2 points) The price of a $0.02 strike 1 year call option on an Indian Rupee is $0.00565.
The price of a $0.02 strike 1 year put option on an Indian Rupee is $0.00342.
Dollar and rupee interest rates are 4.0% and 7.0%, respectively.
How many dollars does it currently take to purchase one rupee?
A. 0.020
B. 0.021
C. 0.022
D. 0.023
E. 0.24
6.5 (2 points) The current exchange rate is $1.90 per British Pound.
A $2 strike 6 month call on the British Pound currently costs $0.0554.
What is the price in pounds of a 0.5 strike 6 month put on United States dollars?
A. 0.010
B. 0.015
C. 0.020
D. 0.025
E. 0.030
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6.6 (2 points) Currently one can buy 1 Brazilian Real for $0.47.
Dollar and Real interest rates are 4.0% and 7.0%, respectively.
The price of a $0.50 strike 6-month call option to buy 1 Brazilian Real is $0.09.
What is the price of a similar put?
A. Less than $0.05
B. At least $0.05, but less than $0.10
C. At least $0.10, but less than $0.15
D. At least $0.15, but less than $0.20
E. At least $0.20
6.7 (2 points) The current exchange rate is $0.15 per Chinese Yuan Renminbi.
An 8 yuan strike 2 year call on the U.S. Dollar currently costs 0.568 yuan.
What is the price in dollars of a $0.125 strike 2 year put on yuan?
A. Less than $0.006
B. At least $0.006, but less than $0.008
C. At least $0.008, but less than $0.010
D. At least $0.010, but less than $0.012
E. At least $0.012
6.8 (2 points) Currently one can buy 1 U.S. Dollar for 11 Mexican Pesos.
Dollar and Peso interest rates are 4.0% and 6.0%, respectively.
The price of a 12 Peso strike 1-year put option on dollars is 1.36 Pesos.
What is the price in Pesos of a similar call?
A. Less than 0.60
B. At least 0.60, but less than 0.70
C. At least 0.70, but less than 0.80
D. At least 0.80, but less than 0.90
E. At least 0.90
6.9 (3 points) The spot exchange rate of dollars per South Korean Won is 0.00097.
Dollar and Won interest rates are 4.0% and 7.0%, respectively.
The price for one million $0.00100 strike 3 year call options on Won is $40.11.
What is the price in Won of a 1000 Won strike 3 year call on dollars?
A. 135
B. 140
C. 145
D. 150
E. 155
2016-MFE,
6.10 (3 points) The spot exchange rate of yen per Euro is 125.
You are given the following premiums for five year Euro denominated calls on yen.
Strike
Premium
0.004
0.003618
0.006
0.002132
0.008
0.001072
0.010
0.000482
0.012
0.000203
0.014
0.000083
Determine the premium for a five year 100 yen strike put on Euros.
A. 5
B. 6
C. 9
D. 13
E. 17
6.11 (3 points) You are given:
(i) The current exchange rate is 1.16/.
(ii) A two-year European call option on Euros with a strike price of 0.80 sells for 0.120.
(iii) The continuously compounded risk-free interest rate on British Pounds is 5%.
(iv) The continuously compounded risk-free interest rate on Euros is 3%.
Calculate the price of 1000 two-year European call options on British Pounds with a strike price of
1.25.
(A) 44
(B) 46
(C) 48
(D) 50
(E) 52
6.12 (CAS5B, 11/93, Q.36) (3.5 points) A U.S. construction company, XYZ Inc., is placing a bid
to build a commercial office in Germany. If accepted, XYZ will be paid its bid (in marks) one week
from today. Assume the following:
A finance manager at XYZ bids 400,000 marks. She wants to insure that no losses from currency
fluctuations can happen if the bid is accepted.
a. (1 point) Discuss the current risk to the manager's company that can occur by the end of the week.
b. (1 point) Advise the manager on how to avoid the losses from currency fluctuations by using a
single option entered into on the day of the bid, ignoring the actual cost of the option and the
time value of money.
c. (1.5 points) Demonstrate through formulas and, when possible, actual amounts how the goal is
achieved under the possible outcomes facing the company.
2016-MFE,
6.13 (CAS5B, 5/99, Q.14) (1 point) An American manufacturer has contracted to sell a large order
of widgets for one million Canadian dollars, with payment due on delivery in six months.
How could the American company reduce foreign exchange risk?
1. Borrow Canadian currency against its receivables, convert to U.S. dollars at the spot rate,
and invest proceeds in the U.S.
2. Buy an option to sell Canadian dollars in six months at a specific price.
3. Buy Canadian currency forward.
A. 1
B. 1, 2
C. 1, 3
D. 2, 3
E. 1, 2, 3
6.14 (CAS3, 11/07, Q.15) (2.5 points)
A nine-month dollar-denominated call option on euros with a strike price of $1.30 is valued at $0.06.
A nine-month dollar-denominated put option on euros with the same strike price is valued at 0.18.
The current exchange rate is $1.2/euro and the continuously compounded risk-free rate on dollars is
7%. What is the continuously compounded risk-free rate on euros?
A. Less than 7.5%
B. At least 7.5%, but less than 8.5%
C. At least 8.5%, but less than 9.5%
D. At least 9.5%, but less than 10.5%
E. At least 10.5%
6.15 (MFE/3F, 5/09, Q.9) (2.5 points) You are given:
(i) The current exchange rate is 0.011$/.
(ii) A four-year dollar-denominated European put option on yen with a strike price of $0.008
sells for $0.0005.
(iii) The continuously compounded risk-free interest rate on dollars is 3%.
(iv) The continuously compounded risk-free interest rate on yen is 1.5%.
Calculate the price of a four-year yen-denominated European put option on dollars with a strike price
of 125.
(A) 35
(B) 37
(C) 39
(D) 41
(E) 43
2016-MFE,
Solutions to Problems:
6.1. C. C$ (x0 , K, T) = P$ (x0 , K, T) + x0 exp[-Tr ] - K e-Tr.
0.28 = P + (1.1)e-(1.5)(0.06) - (0.93)e-(1.5)(0.05). P = $0.137.
6.2. D. CY(x0 , K, T) = PY(x0 , K, T) + x0 exp[-Tr$ ] - K exp[-TrY] =
13 + (120)e-(2)0(.045) - (100)e-(2)(0.03) = 28.5 yen.
Comment: We have a yen denominated option, and therefore yen act as money, while dollars act
as the asset. rY r = return on money. r$ = return on asset (stock).
This is the reverse of what we would do for a dollar denominated option.
6.3. E. Ca(x0 , K, T) = x0 KPb (1/x0 , 1/K, T).
0.05 = (0.4/ Swiss Franc) 0.5 P. P = (.05)(1/.4)/.5 = 0.25 Swiss Francs.
Alternately, the call and the put both have value if three years from now one Swiss Franc is worth
more than 0.5. For example, assume that in 3 years one Swiss Franc is worth 0.6;
in other words, 1 is worth 1.667 Swiss francs. Then the call is worth 0.10, and the put is worth
1/3 Swiss Franc. At that future exchange rate, 1/3 Swiss Franc = 0.2. Thus the put is worth twice the
call. This will be true for other future exchange rates, and thus the put should cost twice the price of
the call. (2)(0.05) = 0.10. At the current exchange rate 0.10 = .1/.4 = 0.25 Swiss Francs.
6.4. D. C$ (x0 , K, T) = P$ (x0 , K, T) + x0 exp[-TrR ] - K e-Tr.
0.00565 = 0.00342 + x0 e-0.07 - .02e-0.04. x0 = $0.0230.
6.5. B. C$ (x0 , K, T) = x0 K Pf(1/x0 , 1/K, T).
$0.0554 = (1.90)(2) P . P = 0.0146 pounds.
Alternately, Sam buys 10,000 calls.
In six months, Sam will have the option to buy 10,000 pounds for $20,000.
Sams position is worth (10,000)($0.0554) = $554.
Nigel buys 20,000 puts.
In six months, Nigel will have the option to sell $20,000 for 10,000 pounds.
Sam and Nigels positions are equivalent.
Nigels position must be currently worth $554 or 554/1.90 = 291.58 pounds.
Thus, each of Nigels puts must be worth: 291.58 pounds / 20,000 = 0.0146 pounds.
2016-MFE,
2016-MFE,
$ denominated call
$ denominated put
Sam-Johann
Sam-Johann
Put-Call Parity
2016-MFE,
6.10. B. A Euro denominated call on yen is similar to a yen denominated put on Euros.
A 100 yen strike put on Euros, gives one the opportunity to sell 1 Euro for 100 yen.
We can obtain 100 yen for 1 Euro.
This is the same as 100 calls in which we can pay 1/100 = 0.01 Euros per yen.
These one hundred 0.01 Euro strike calls on yen cost: (100)(0.000482 Euros) = 0.0482 Euros.
At the current exchange rate this is: (125)(0.0482) = 6.025 yen.
Alternately, Pyen(x0 , K, T) = x0 K CEuro(1/x0 , 1/K, T) = (125)(100)CEuro(1/125, 1/100, 5)
= 12,500 CEuro(0.08, 0.010, 5) = (12,500)(0.000482) = 6.025 yen.
6.11. B. One Euro currently costs 1/1.16 British Pounds.
By put-call parity, (with Pounds acting as money and Euros acting as the asset,) a two-year
pound-denominated European put option on Euros with a strike price of 0.80 sells for:
0.120 - (1/1.16) exp[-(2)(3%)] + 0.80 exp[-(2)(5%)] = 0.0320.
C (x0 , K, T) = x0 K P (1/x0 , 1/K, T) = (1.16)(1.25)(0.0320) = 0.0464. (1000)(0.0464) = 46.4.
Alternately, P(x0 , K, T) = x0 K C (1/x0 , 1/K, T) = (1.16)(1.25)(0.120) = 0.174.
By put-call parity, (with Euros acting as money and pounds acting as the asset,) a two-year
Euro-denominated European call option on British Pounds with a strike price of 1.25 sells for:
0.174 + 1.16 exp[-(2)(5%)] - 1.25 exp[-(2)(3%)] = 0.0464. (1000)(0.0464) = 46.4.
Comment: Similar to MFE/3F, 5/09, Q.9.
2016-MFE,
6.12. (a) By the end of the week the exchange rate may change. If the bid is accepted, the
400,000 marks XYZ will be paid will not be worth $200,000. XYZ is concerned that the exchange
rate will go down, for example to $0.45 per mark, in which case the 400,000 marks will be worth less
than $200,000.
(b) Buy mark-denominated calls on dollars to allow one to use marks to buy dollars.
Equivalently, buy dollar-denominated puts on marks, to allow one to sell marks for dollars.
The options should be at-the-money and have one week to expiration.
(c) There are four possibilities.
1. If XYZ does not get the bid, and the exchange rate increases, then it lets the options expire.
2. If XYZ does not get the bid, and the exchange rate decreases, then its options turn a profit.
3. If XYZ does gets the bid, and the exchange rate increases, then it lets the options expire.
4. If XYZ does gets the bid, and the exchange rate decreases, then it uses it options to convert the
400,000 marks it receives into $200,000.
Comment: Since the creation of the Euro, there are no longer German marks.
In any case, you should take this simplified example with a grain of salt.
A forward contract to buy dollars for marks at $0.50 per mark would not do as good a job of
hedging. If XYZ does not get the bid, and thus has no need to convert marks to dollars, and the
exchange rate increases, then it would lose money on the futures contract. For example, if the
exchange rate in one week were $0.55, then XYZ would have to buy marks at $0.55 in order to sell
them for $0.50 to the other party to the futures contract.
(The futures contract may just be settled monetarily. In any case, XYZ would lose money.)
Of course the puts or calls would cost money to buy.
6.13. B. Buying a Canadian currency forward would obligate you to buy a specified number of
Canadian dollars for a specified price in six months. The American company would reduce its foreign
exchange risk by selling a Canadian currency forward, which would obligate it to sell one million
Canadian dollars for a specified price in six months.
6.14. D. C = P + X0 exp[-T reuro] - K exp[-T r$ ].
0.06 = 0.18 + 1.2 exp[-0.75 reuro] - 1.3 exp[-(0.75)(0.07)].
2016-MFE,
6.15. E. By put-call parity, (with dollars acting as money and yen acting as the asset,) a four-year
dollar-denominated European call option on yen with a strike price of $0.008 sells for:
$0.0005 + $0.011 exp[-(4)(1.5%)] - $0.008 exp[-(4)(3%)] = $0.003764.
C $ (x0 , K, T) = x0 K P (1/x0 , 1/K, T). 0.003764 = (0.011)(0.008) P (1/0.011, 1/0.008, 4).
2016-MFE,
Exercise
Exchange
Call?
100
90
Yes
110
130
No
120
100
Yes
70
80
No
A similar put exchange option would instead allow us to sell stock Able in exchange for stock Baker,
in other words, get Baker in exchange for Able.
133
See Section 9.2 of Derivatives Markets by McDonald. Also called an outperformance option.
2016-MFE,
Put-Call Parity:
Buy one European exchange call allowing one to use B to get A, sell a similar put, sell a prepaid
forward contract on Stock A, and buy a prepaid forward contract on Stock B.134
At Time T, you will get a share of Stock B due to the forward contract you bought.
If ST QT, you will exercise your call and exchange your Share of Stock B for a Share of Stock A.
Then you will provide this share of Stock A to the person who bought a forward contract from you.
If instead ST < QT, then the person who bought your put, will exchange a share of Stock A for your
share of Stock B. You will then provide this share of Stock A to the person who bought a forward
contract from you.
In either case, at time T you end up with nothing after all of the transactions.
Therefore, the correct price for this position is zero.
P (S) be the prepaid forward price of a share of Stock A.
Let F0,T
P (Q) be the prepaid forward price of a share of Stock B.
Let F0,T
P (S) + F P (Q).
We have shown that: 0 = CEur(S0 , Q0 , T) - PEur(S0 , Q0 , T) - F0,T
0,T
P (S) - F P (Q). 135 136
C E u r( S0 , Q0 , T) = PE u r( S0 , Q0 , T) + F0,T
0,T
If the current price of Stock A is $100 and the current price of Stock B is $120, and neither one pays
P (S) = 100 and F P (Q) = 120. Therefore,
dividends, then F0,T
0,T
Under a prepaid forward contract, you pay now but receive the asset at a fixed point of time in the future.
See Equation 9.8 in Derivatives Markets by McDonald.
136
This put-call parity follows from the fact that: (S(T) - Q(T))+ + Q(T) = (Q(T) - S(T))+ + S(T).
See remark (iii) on MFE Sample Exam Q.55.
135
2016-MFE,
Transaction
Time 0
-C
Sell Put
Total
At Expiration (TIme T)
If ST QT
if ST> QT
0
S T - QT
S T - QT
P (S)
F0,T
-ST
-ST
P (Q)
- F0,T
QT
QT
P (S) - F P (Q)
P - C + F0,T
0,T
Therefore, the premium of the put is equal to the premium of the similar call, if and only if the two
stocks have the same prepaid forward price.
137
2016-MFE,
Note that this form of put-call parity includes the situations previously discussed as special cases.
For example, if the strike asset is money, specifically K dollars, then the dividend on money is
interest at rate r, and
C Eur(S0 , K, T) = PEur(S0 , K, T) + S0 exp[-TS] - K exp[-Tr].
Parity is the observation that buying a European call and selling a European put with
the same strike price and time to expiration is equivalent to making a leveraged
investment in the underlying asset, less the value of cash payments to the underlying
asset over the life of the option.139
Points of View:
As discussed previously, a call from one point of view is a put from another point of view.
Leonard has a 2 year European call with underlying asset Stock A and strike asset Stock B.
Leonard has the option 2 years from now to buy a share of Stock A in exchange for a share of
Stock B. He will do so if two years from now Stock A is worth more than Stock B.
Sheldon has instead a 2 year European put with underlying asset Stock B and strike asset Stock A.
Sheldon has the option 2 years from now to sell a share of Stock B in exchange for a share of
Stock A. He will do so if two years from now Stock A is worth more than Stock B.
Leonard and Sheldon own options which provide the same possibilities, and therefore their options
have the same value.
C ( S0 , Q0 , T) = P(Q0 , S0 , T).
Call to buy Stock A for price Stock B: A is the underlying asset and B is the strike asset.
Put to sell Stock B for price Stock A: B is the underlying asset and A is the strike asset.
Despite the different language, both give you the option to use Stock B to obtain Stock A.
139
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Problems:
7.1 (2 points) Consider the case of a European exchange option in which the underlying stock is
Widget Co. with a current price of $65 per share. The strike asset is Gadget Inc., with a per share
price of $62. Neither stock will pay dividends within the next 3 months. Interest rates are 5% and the
3 month call option is trading for $8. What is the price of the similar put?
A. 3 B. 5 C. 7 D. 9 E. 11
7.2 (2 points) A 2 year European exchange call option has underlying asset one share of MGH
Shipping with a current price of $100 per share. The strike asset is 2 shares of Galactus Transport,
with a per share price of $60. One will have the option to use 2 shares of Galactus in order to obtain
one share of MGH. The price of this call option is $11.
MGH Shipping pays dividends at a continuous rate of 2% per year.
Galactus Transport pays dividends at a continuous rate of 1% per year.
What is the price of the similar put?
A. Less than $20
B. At least $20, but less than $25
C. At least $25, but less than $30
D. At least $30, but less than $35
E. At least $35
7.3 (2 points) A 3 year European exchange option has underlying asset one share of Peach
Computer Company with a current price of $200 per share. The strike asset is the Silicon Valley
Stock Index, with a current price of $210. The price of this call option is $13.
Peach Computer Company pays dividends at a continuous rate of 3% per year.
Silicon Valley Stock Index pays dividends at a continuous rate of 1% per year.
What is the price of the similar put?
A. Less than $20
B. At least $20, but less than $25
C. At least $25, but less than $30
D. At least $30, but less than $35
E. At least $35
7.4 (2 points) Consider four-year European exchange options involving the stocks of Global
Dynamics and Deon International. The price of an option to exchange a share of Global Dynamics
for a share of Deon International is the same as the price of an option to exchange a share of Deon
International for a share of Global Dynamics.
Global Dynamics has a current price of 92 and pays dividends at a continuous rate of 2% per year.
Deon International pays dividends at a continuous rate of 0.9% per year.
What is the current price of a share of Deon International?
A. 85
B. 86
C. 87
D. 88
E. 89
2016-MFE,
7.5 (2 points) Daedalus stock has a current price of $65, and will pay a dividends of $1 in 2 months
and 5 months.
Hooper stock has a current price of $60, and will pay dividends of $1 in 1 month and 4 months.
A six month put on Daedalus stock with strike asset of Hooper stock costs $2.79.
If r = 6%, determine the cost of the similar call.
A. 7.00
B. 7.20
C. 7.40
D. 7.60
E. 7.80
7.6 (2 points) Parallax stock will pay quarterly dividends of $3 in 1 month, 4 months, etc.
Megadodo stock will pay quarterly dividends of $2 in 2 months, 5 months, etc.
A one year call on Parallax stock with strike asset of Megadodo stock costs $7.
A one year call on Megadodo stock with strike asset of Parallax stock costs $4.
If r = 9%, determine the difference in the current stock prices of Parallax and Megadodo.
A. 6.50
B. 6.70
C. 6.90
D. 7.10
E. 7.30
2016-MFE,
Solutions to Problems:
P (S ) - F P (Q ).
7.1. B. CEur(S0 , Q0 , T) = PEur(S0 , Q0 , T) + F0,T
0
0
0,T
8 = P + 65 - 62. P = $5.
Comment: Since there are no dividends, the prepaid forward price is the same as the current stock
price. The interest rate has no impact.
P (S ) - F P (Q ).
7.2. D. CEur(S0 , Q0 , T) = PEur(S0 , Q0 , T) + F0,T
0
0
0,T
Therefore, the premium of the put is equal to the premium of the similar call, if and only if the two
stocks have the same prepaid forward price.
Prepaid forward price of Global Dynamics is: 92 exp[-(4)(0.02)] = 84.93.
Prepaid forward price of Deon International is: Q0 exp[-(4)(0.009)].
Q 0 exp[-(4)(0.009)] = 84.93. Q0 = 88.04.
7.5. E. Prepaid forward price of Daedalus is: 65 - 1/exp[1%] - 1/exp[2.5%] = 63.03.
Prepaid forward price of Hooper is: 60 - 1/exp[0.5%] - 1/exp[2%] = 58.02.
P (S) - F P (Q) = 2.79 + 63.03 - 58.02 = $7.80.
C = P + F0,T
0,T
Comment: A one year call on Megadodo stock with strike asset of Parallax stock is equivalent to a
one year put on Parallax stock with strike asset of Megadodo stock.
2016-MFE,
See Section 5.4 of Derivatives Markets by McDonald, on the syllabus of a previous exam.
One can think of mark to market as follows, as the for ward price moves up or down the owner of the futures
contract either makes or loses money right away.
In contrast, for a forward contract the profit or loss is realized at expiration.
142
Futures contracts can be on other assets like gold, stock indices such as the S&P 500, currency such as yen, etc.
143
A contract would be for 5000 bushels, so Frank has actually sold two contracts.
144
Some futures contracts are settled by delivery, but most are closed out prior to the delivery date.
When you enter into a futures contract you are obligated to make payments if the forward price moves in the wrong
direction for you. Thus the effect of the movement in the forward price is captured monetarily on an ongoing basis.
145
Therefore, Frank will take his profit now, and the new futures price is $3.99.
141
2016-MFE,
By buying an option on a futures contract Frank would get price protection without limiting his profit potential.
There are two important dates: when the option expires, June, and the delivery date in the futures contract, July.
One could instead of a European option have an American option, to be discussed subsequently. In that case, one
could exercise the option at any date up to expiration. Options on futures contracts are often American, with
expiration date one month before the delivery date of the commodity.
147
2016-MFE,
Assume for example the strike price were $4.00 per bushel. Then in June, Frank would have the
option to exercise his put and enter into an agreement to deliver wheat in July at $4.00 per bushel.
If the futures price in June were more than $4.00 per bushel, then Frank would not exercise his put. If
instead the futures price in June were less than $4.00 per bushel, then Frank would exercise his put.
For example, if the futures price in June when the option expires were $3.80 per bushel, then Frank
would exercise his put.148 Frank would now have locked in a price of $4.00 per bushel for his wheat,
which is better than the $3.80 he could get by entering into a futures contract in June.149
The payoff to Frank from the put would be: $4.00 - $3.80 = $0.20 per bushel. The payoff on his
put is: (Strike Price - Futures Price)+. This is the same payoff formula as for a put on stock, with the
futures price taking the place of the stock price. Thus even though there is no money required to
invest in a futures contract, one can apply the same mathematics to options on futures contracts as to
options on stocks, with appropriate modifications.150
Such a put would protect Frank against the price of wheat declining between March and June. If such
a price decline occurs, Franks wheat is worth less, but his put is worth more.
Similarly, on March 15, Moms Bakery could purchase a 3 month $4 per bushel strike call to buy a
futures contract on 10,000 bushels of wheat for July delivery. This call would give Moms Bakery the
option to buy in June such a futures contract. In June, Moms would have the option to exercise its
call and enter into an agreement to accept delivery of wheat in July at $4.00 per bushel.
If the futures price in June were less than $4.00 per bushel, then Moms Bakery would not exercise
this call. If the futures price in June were more than $4.00 per bushel, then Moms Bakery would
exercise this call.
If for example the futures price in June were $4.10 per bushel, then Moms would exercise its call
and now have entered into a futures contract to receive wheat in July for $4.00 a bushel. Moms
would now have locked in a price of $4.00 per bushel for buying wheat, which is better than the
$4.10 it could get via a futures contract. The payoff to Moms from the call would be: 4.10 - 4.00 =
$0.10 per bushel. The payoff on this call is: (Futures Price - Strike Price)+. This is the same payoff
formula as for a call on stock, with the futures price taking the place of the stock price.
Such a call would protect Moms Bakery against the price of wheat increasing between March and
June. If such a price increase occurs, Moms Bakery would have to pay more for wheat, but the call
is worth more.
148
Alternately, Frank could make money by selling his put which would have increased in value.
In June, Frank could enter into a futures contract for July delivery of wheat with a $3.80 per bushel price.
Instead using his put option on a futures contract, Frank can enter into afutures contract in June for July delivery of
wheat with a $4.00 per bushel price.
150
A form of put-call parity for options on future contracts will be discussed subsequently. In subsequent sections,
will be discussed how to price options on futures contracts, using either Binomial Trees or the Black-Scholes
formula, in a manner parallel to pricing options on stocks.
149
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Advantages of Using Options on Futures rather than Options on the Underlying Asset:151
Options on futures contracts are preferable to options on the underlying asset when it is cheaper
and/or more convenient to deliver/receive the futures contract on the asset rather than the asset itself.
It is easier to deliver or receive a futures contract on cattle than it is to deliver or receive the cattle.
The futures contract will usually be closed out prior to delivery, and therefore, options on futures
contracts are usually settled in cash.
In many situations options on futures contracts tend to have lower transaction costs than options on
the underlying asset.
Trading on futures and options on futures are usually conducted side by side on the same
exchange, which makes it easier to hedge, etc., and makes the markets more efficient.
Put-Call Parity for Options on Futures Contracts:152
The put-call parity relationship for options on futures contracts is:
C = P + F0 e-rT - Ke-rT.
F0 is the futures price at time zero for the delivery time in the futures contract underlying the options,
and T is the time from when the option is bought to when it expires.
The put-call parity relationship for options on futures contracts can be obtained from
that for options on stocks by: S0 F0 , and r.
Exercise: On March 15 a 3 month $4 per bushel strike put on a futures contract on 10,000 bushels
of wheat for July 15 delivery has a premium of $815. (The buyer of this put would on June 15
have the option to sell, to the person who wrote the put, a futures contract on 10,000 bushels of
wheat for July 15 delivery at $4 per bushel.)
Currently, the futures price for July 15 delivery of wheat is $4.20 per bushel.
If r = 5%, what is the premium for the corresponding call?
[Solution: C = P + F0 e-rT - Ke-rT =
$815 + (10,000)($4.20) e-(0.05)(1/4) - (10,000)($4.00) e-(0.05)(1/4) = $2790.
Comment: The $4.20 futures price is just another input; it is the futures price for July 15 delivery as
per the underlying futures contracts.
The options expire on June 15.]
151
152
See Options, Futures, and Other Derivatives by Hull, not on the syllabus.
See page 355 of Derivative Markets by Mcdonald.
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Problems:
8.1 (2 points) A futures contract provides for the delivery of 1000 barrels of Light Sweet Crude Oil
in September.
In January, a 4 month $100 per barrel strike call on this futures contract has a premium of $3400.
In January, the futures price for delivery of oil in September is $95 per barrel.
If r = 6%, determine the premium for the corresponding put.
A. $7900
B. $8000
C. $8100
D. $8200
E. $8300
8.2 (2 points) The premium for a 6 month 1500-strike put on a futures contract is 53.
The current futures price is 1600.
If r = 4%, determine the premium for the corresponding call.
A. 130
B. 140
C. 150
D. 160
E. 170
8.3 (3 points) On January 1, Saul enters into a futures contract on 5000 bushels of soybeans at
$12.40 per bushel for delivery in August. Saul has a long position; he has agreed to accept delivery
of soybeans in August. Saul post a margin of 10%. The interest rate is 6%.
The futures prices for August delivery are on the following dates:
January 1
$12.40
January 2
$12.60
January 3
$12.55
January 4
$12.30
January 5
$12.40
Determine the amount in Sauls margin account on each of these days.
8.4 (1 point) The premium for an at-the-money call on a futures contract is $5. What is the premium
for an at-the-money put on the same futures contract with the same time until maturity?
8.5 (2 points) The premium for a 9 month 200-strike call on a futures contract is 21.
The current futures price is 192.
If r = 5%, determine the premium for the corresponding put.
A. 29
B. 31
C. 33
D. 34
E. 36
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Solutions to Problems:
8.1. E. P = C - F0 e-rT + Ke-rT =
$3400 - (1000)($95) e-(0.06)(1/3) + (1000)($100)e-(0.06)(1/3) = $8301.
Comment: An airline might either enter into a futures contract or buy a call on a futures contract in order
to protect itself against a possible future rise in oil prices, which would lead to a rise in the price of jet
fuel.
8.2. C. C = P + F0 e-rT - Ke-rT = 53 + (1600) e-(0.04)(1/2) - (1500) e-(0.04)(1/2) = 151.
8.3. Sauls original margin account is: (10%)(5000)($12.40) = $6200.
When on January 2 the futures price increases $.20 per bushel he makes ($.20)(5000) = $1000.
(He would be getting soybeans for only $12.40 per bushel rather than the expected $12.60.)
He also made one days interest.
On January 2 his margin account is: $6200 exp[.06/365] + $1000 = $7201.02.
On January 3 his margin account is: $7201.02 exp[.06/365] + (-$.05)(5000) = $6952.20.
On January 4 his margin account is: $6952.20 exp[.06/365] + (-$.25)(5000) = $5703.34.
On January 5 his margin account is: $5703.34 exp[.06/365] + ($.10)(5000) = $6204.28.
Comment: See Table 5.8 in Derivatives Markets by McDonald, on the syllabus of an earlier exam.
Here Saul has a long position, so he benefits from increases in the future price. If instead he had a
short position, had agreed to deliver soybeans at a predetermined price, then he would benefit
from decreases in the futures price.
8.4. At-the-money means K = F0 .
C = P + F0 e-rT - Ke-rT. 5 = P + F0 e-rT - F0 e-rT. P = $5.
8.5. A. C = P + F0 e-rT - Ke-rT. 21 = P + (192) e-(0.05)(3/4) - (200) e-(0.05)(3/4). P = 28.71.
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156
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We can create a synthetic put by buying a call, shorting the stock, lending the present value of the
strike price, and lending the present value of any dividends.
Exercise: Show that this position is equivalent to buying the put.
[Solution: We borrow a share of stock, sell it for S0 , and will give this person a share of stock when
the option expires. We also must pay this person the stock dividends they would have gotten on
the stock, when they would have gotten them. We pay the dividend payments from one of the
loans. If ST K, then we buy a share for K, using our call and the money from the other loan.
After returning the share to the person we borrowed it from, we are left with nothing.
If instead ST < K, then we buy a share for ST. After returning the share to person we borrowed it
from, we are left with K - ST. These are the same payoffs as if we had purchased the put.]
This shows that PEur(K, T) = CEur(K, T) - S0 + K e-rT + PV[Div], one of the put-call parity
relationships discussed previously.
In the case of continuous dividends, PEur(K, T) = CEur(K, T) - e-TS 0 + K e-rT.
Thus we can create a synthetic put by buying a call, shorting e-T shares of stock,
and lending the present value of the strike price.
C Eur(K, T) = PEur(K, T) + e-TS 0 - K e-rT.
Thus we can create a synthetic call by buying a put, buying e-T shares of stock,
and borrowing the present value of the strike price.
In the case of discrete dividends, CEur(K, T) = PEur(K, T) + S0 - K e-rT - PV[Div].
Thus we can create a synthetic call by buying a put, buying a share of stock, borrowing the present
value of the strike price, and borrowing the present value of any dividends.
Synthetic Forward Contract:157
We can create a synthetic forward contract by buying a call and selling a put.
If ST K, then we buy a share for K, using our call.
If instead ST < K, then we buy a share for K, from the person to whom we sold the put.
Thus we have a forward contract to buy the stock at price K. This has present value PV0,T[F0,T - K].
Therefore, PV0,T[F0,T - K] = CEur(K, T) - PEur(K, T), as discussed previously.
157
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158
159
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Problems:
9.1 (2 points) The price of a stock is $135. The stock pays dividends at the continuous rate of 2%.
The price of a European call with a strike price of $140 is $17.39 and the price of a European put
with a strike price of $140 is $19.14. Both options expire in eight months.
Calculate the annual continuously compounded risk-free rate on a synthetic T-Bill created using these
options.
A. Less than 3%
B. At least 3%, but less than 3%
C. At least 4%, but less than 4%
D. At least 5%, but less than 6%
E. At least 6%
9.2 (2 points) Consider options on a non-dividend paying stock.
The price of a 3 year European call with a strike price of $100 is $39.70.
The price of a 3 year European put with a strike price of $100 is $8.23.
r = 6%.
Calculate the price of a synthetic share of stock created using these options.
A. 100
B. 105
C. 110
D. 115
E. 120
9.3 (3 points) The stock of Rich Resorts has a current price of 150, and pays no dividends.
The stock of Cereal Growers has a current price of 80, and pays no dividends.
This coming summer will either be dry or wet.
If the summer is dry, then 4 months from now Rich Resorts stock price will be 180,
and Cereal Growers stock price will be 70.
If the summer is wet, then 4 months from now Rich Resorts stock price will be 130,
and Cereal Growers stock price will be 90.
What is the continuously compounded risk free rate?
A. 3.25%
B. 3.50%
C. 3.75%
D. 4.00%
E. 4.25%
9.4 (2 points) Consider options on a dividend paying stock.
The price of a 9-month European call with a strike price of $60 is $5.67.
The price of a 9-month European put with a strike price of $60 is $7.52.
r = 7%.
Using these options you create a synthetic 9-month forward contract on a share of stock.
Calculate the price, with payment on delivery, of this forward contract.
A. 55
B. 56
C. 57
D. 58
E. 59
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Solutions to Problems:
9.1. D. Using put call parity, C = P - Ke-rT + Se-T.
17.39 = 19.14 - 140 e-r2/3 + 135 e-(0.02)(2/3). e-r2/3 = 134.96/140. r = 5.5%.
Comment: Similar to CAS3, 5/07, Q.13.
9.2. D. From put-call parity, PEur(K, T) = CEur(K, T) - S0 + K e-rT + PV[Div].
8.23 = 39.70 - S0 + 100 e-.18 + 0. S0 = $115.00.
9.3. E. Assume we buy x shares of Rich Resorts and y shares of Cereal Growers.
Then after a dry summer our position is worth: 180x + 70y.
After a wet summer our position is worth: 130x + 90y.
Setting these two equal: 180x + 70y = 130x + 90y. y = 2.5x.
Take for example x = 2 and y = 5. Then the portfolio costs: (2)(150) + (5)(80) = 700.
If the summer is dry, then 4 months from now the portfolio is worth: (2)(180) + (5)(70) = 710.
If the summer is wet, then 4 months from now the portfolio is worth: (2)(130) + (5)(90) = 710.
Thus we have a risk free return. 710/700 = er/3. r = 4.26%.
Comment: We want to create a risk free investment, a synthetic treasury bill.
What we were asked to determine, r, is the return on a such risk free bond.
We equate the value of the portfolio in the two possible future states.
In the case where we buy 2shares of Rich Resorts and 5 shares of Cereal Growers, our portfolio
will be worth 710 in either state.
An investment that is always worth a fixed amount in the future is just like a risk free bond.
9.4. D. Prepaid Forward Price is: e-T S0 = C - P + e-rT K = 5.67 - 7.52 + 60 e-(0.07)(0.75) = 55.08
Forward Price = erT (prepaid forward price) = e(0.07)(0.75) 55.08 = 58.05.
9.5. D. Using put-call parity, C = P - Ke-rT + Se-T.
4.51 = 5.92 - 80 e-r/3 + 77 e-0/3. e-r/3 = 78.41/80 = 0.9801. r = 6.0%.
Comment: Similar to CAS3, 5/07, Q.13.
K e-rT = S e-T + P - C. A synthetic T-Bill can be created by buying the stock, buying the put, and
selling the call. If the stock paid dividends, then one would need to buy a forward contract on the
stock in order to create a synthetic T-Bill.
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Recall that for a European style option, Jim would get the option to sell a share of stock on only a single day.
See Section 9.3 of Derivatives Markets by McDonald.
162
Appendix 9.A of McDonald, not on the syllabus, discusses parity bounds for American options.
CAmer(S0 , K, T) + K - PV0,T[F0,T] PAmer(S0 , K, T) CAmer(S0 , K, T) + PV0,T[K] - S.
P Amer(S0 , K, T) + S - PV0,T[K] CAmer(S0 , K, T) PAmer(S0 , K, T) + PV0,T[F0,T] - K.
Note that for European Options, CEur(S0 , K, T) + K - PV0,T[F0,T] CEur(S0 , K, T) + PV0,T[K] - PV0,T[F0,T]
= PEur(S0 , K, T) CEur(S0 , K, T) + PV0,T[K] - S.
163
See Equation 9.9 in McDonald.
164
Not discussed in Derivatives Markets by McDonald. If S0 > K, in other words if the call is in the money, then one
could exercise the American call immediately, getting a payoff of S0 - K.
If the dividend rate is small, then PV0,T[F0,T] - PV0,T[K] > S0 - K.
If the dividend rate were large, such as when dealing with options on currency, the reverse could be true.
161
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165
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Exercise: Olivia and Tracy have purchased puts with strike prices of $100.
At time = 1 the stock is worth $0.01. Whose option is worth more?
[Solution: Olivia exercises her option at time = 1 and makes $99.99.
The present value is $99.99e-r.
The most Tracy can make by exercising her option at time = 2 is $100.
The present value is $100e-2r, less than $99.99e-r for any reasonable value of r.
Comment: We have shown that it is possible that a European put could be worth less than a similar
option with less time until expiration.]
Exercise: Olivia and Tracy have purchased calls with strike prices of $100.
At time = 1 the stock is worth $125. At time equal 1.1 the stock will pay a dividend of $120.
Whose option is worth more?
[Solution: Olivia exercises her option at time = 1 and makes $25.
After paying the very large dividend, the price of the stock will decline to something in the range of
$5. It is extremely unlikely that the price of the stock by time = 2 will exceed 100. At time = 2, the
only time Tracy can exercise her option, it is very unlikely that her call option is in the money.
Tracys option will almost always turn out to be worthless.
Comment: We have shown that it is possible when dividends are paid that a European call could
be worth less than a similar option with less time until expiration.]
For European calls on stocks that do not pay dividends, the premium is the same as that of the
corresponding American call. Therefore, for a European call on a given non-dividend paying
stock, the call is worth at least as much as a similar call with less time to expiration.
However, the same relationship does not necessarily hold for either European calls on
stocks that pay dividends, or for European puts.169
Early Exercise:
It turns out that for an American option, depending on the current price of the stock, the strike price,
and the time until expiration, etc., sometimes it is worthwhile to exercise the option prior to the
expiration date, and sometimes it is not. Here we are talking about the present value of each
strategy, rather than a 20-20 hindsight view of what actually turned out to happen to the stock price
after one had made a decision.
As will be shown subsequently, if the stock pays no dividends, then it is never worthwhile
to exercise an American call option early.170
169
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Jim can exercise his option on any day through expiration. I have only looked at three points in time for simplicity.
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See pages 294 to 296 and Section 11.1 of Derivatives Markets by McDonald.
A dividend is paid to the person who owns the stock on a specific day. If for example that day is March 30, and if
one buys the stock on March 31, then the price is ex-dividend. If Dave buys the stock from Judy on March 31, Judy
will receive the dividend, even if the dividend is actually paid in early April.
174
See equation 9.11 in Derivatives Markets by McDonald.
173
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For American calls there are two reasons to wait and one reason to exercise early:
1. The time value of the strike price is lost if one exercises early.
2. The implicit insurance protection against the stock price moving below the strike price
is lost if one exercises early.
3. The value of dividends is gained if one exercises early.
If we exercise early, then we spend the strike price. If instead we were to wait to exercise, then we
do not spend the strike price and we can earn interest on that money.
If we exercise early, then we own the stock, and risk the stock price going down. If instead we were
to wait to exercise, then we retain this implicit insurance protection against the stock price moving
below the strike price.175 176 Put another way, if we wait to exercise the call, we avoid the possibility
of capital losses on the stock.
If we exercise the call early, then we own the stock and get the dividends.
C Amer(St, K, T - t) CEur(St, K, T - t) = PEur(St, K, T - t) + PVt,T[Ft,T] - PVt,T[K]
PVt,T[Ft,T] - PVt,T[K]. Therefore, CAmer PV[Ft,T] - PV[K], as discussed previously.
The payoff for exercising early an American call at time t is:
S t - K = PV[Ft,T] + PV[Div] - PV[K] - (K - PV[K])
= PV[Ft,T] - PV[K] + PV[Div] - (K - PV[K]) CAmer(St, K, T - t) + PV[Div] - (K - PV[K]).
Therefore, if PVt,T[Div] - (K - PVt,T[K]) < 0, then St - K CAmer,
and it would not be worthwhile to exercise early.
If K - PVt , T[K] > PVt , T[Div], then one should not exercise an American call early
at time t.177 178 In other words, if K{1 - exp[-r(T- t)]} is greater than the present value of the future
dividends that will be paid until the call expires, then it is better to wait rather than exercise early.
For example, if K = $100, r = 5%, and there are 6 months to expiration of an American call, then if
PV[Div] < 100(1 - e-0.025) = $2.47, it would not be worthwhile to exercise at this time. For example,
if there is a single $2 dividend tomorrow it would not be worthwhile to exercise at this time.
In this case, the benefit of getting interest on the strike price exceeds the benefit from exercising
early and thus receiving the stock dividends; therefore, it is optimal to wait.
175
Personally, I do not find McDonalds use of the term insurance implicit in the call to be helpful.
This implicit protection can be thought of as the implicit put from put-call parity. The larger , the larger the value of
this implicit put, and thus the less likely it will be optimal to exercise early, all else being equal.
177
See Equation 9.14 in Derivatives Markets by McDonald. K - PVt,T[K] = K(1 - exp[-r(T- t)])
Specifically, if there are no dividends, then one should not exercise an American call early.
178
If K - PV[K] < PV[Div], then it may or may not make sense to exercise an American call early.
Another necessary condition to exercise early an American call is that St > K.
176
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If instead, PV[Div] > $2.47, then it might be worthwhile to exercise at this time. For example, if there
is a single $3 dividend two months from now, then PV[Div] = 3e-0.05/6 = 2.98 > 2.47, and it might
be worthwhile to exercise at this time.
In this case, the benefit from exercising early and thus receiving the stock dividends exceeds the
benefit of getting interest on the strike price. However, if we exercise early, besides losing the
interest on the strike, we would also lose the implicit insurance protection. Therefore, it may or may
not be optimal to exercise early. In general, it may be optimal to exercise early an American Call if
the dividend rate is large compared to the risk free rate.
In fact, CAmer(St, K, T - t) PEur(St, K, T - t) + PVt,T[Ft,T] - PVt,T[K].
Therefore, the payoff for exercising early an American call at time t is:
St - K = PV[Ft,T] + PV[Div] - PV[K] - (K - PV[K]) = PV[Ft,T] - PV[K] + PV[Div] - (K - PV[K])
CAmer (St, K, T - t) - PEur(St, K, T - t) + PV[Div] - (K - PV[K]).
Therefore, if PVt,T[Div] - (K - PVt,T[K]) - PEur(St, K, T - t) < 0, then St - K CAmer,
and it would not be worthwhile to exercise early.
If PEur(St, K, T - t) + K - PVt,T[K] > PVt,T[Div], then one should not exercise an American call
early at time t.179 If were to exercise an American Call early, then we would own the stock and
collect its dividends, but we would lose the interest on the strike price and also lose the implicit
insurance protection represented by the put premium.
Let us assume there is a single $3 dividend two months from now.
Jubal and Anderson each have identical 6 month $100 strike American calls.
Jubal exercises his call now, pays $100 and owns the stock.
Anderson instead invests $100 e-0.05/6 = $99.17 at the risk free rate for two months.
Two months from now, just before the dividend is paid, Anderson has $100 and uses it exercises
his call and own the stock. At that point in time both Jubal and Anderson own the stock and get the
dividend payment. However, Jubal invested $100 today, while Anderson only invested $99.17.
Thus Andersons strategy was better.180
In general, if it is optimal to exercise an American call early, and dividends are paid at
discrete times, then it is best to exercise right before the payment of a (large) dividend,
in other words at the last moment before the ex-dividend date.181
179
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See pages 278 to 279 and Section 11.1 of Derivatives Markets by McDonald.
This implicit protection can be thought of as the implicit call from put-call parity. The larger , the larger the value of
this implicit call, and thus the less likely it will be optimal to exercise early, all else being equal.
184
See page 286 of Derivatives Markets by McDonald.
183
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sigma= 0.5
300
250
sigma= 0.3
200
150
Time
We note two features. First, as increases, the exercise boundary is higher. For larger , the implicit
insurance protection is larger. Therefore, the larger , the larger the continuation value. Therefore, a
higher stock price, and thus a higher value of exercising the call immediately, is required in order to
make it worthwhile to exercise the option early.
Second, as the option gets closer to expiration, the exercise boundary approaches the strike price.
As the option approaches expiration, one would lose less insurance protection by exercising early.
185
Based on Figure 11.1 of Derivatives Markets by McDonald, which was computed using Binomial Trees, to be
discussed subsequently. The volatility will be discussed in subsequent sections.
186
While one needs to know how to work with Binomial Trees, the huge amount of work required to determine the
exercise boundary is well beyond what you could be required to do on the exam, even if one were supplied with a
computer!
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The following graph shows early exercise boundaries for a 5-year 100 strike American put, for
either 30% or 50%:187
Stock Price
100
90
80
70
60
sigma= 0.3
50
40
sigma= 0.5
30
1
Time
We note two features. First, as increases, the exercise boundary is lower. For larger , the implicit
insurance protection is larger. Therefore, the larger , the larger the continuation value. Therefore, a
lower stock price, and thus a higher value of exercising the put immediately, is required in order to
make it worthwhile to exercise the option early.
Second, as the option gets closer to expiration, the exercise boundary approaches the strike price.
As the option approaches expiration, one would lose less insurance protection by exercising early.
For both puts and calls, the early-exercise criterion becomes less stringent as the option
has less time until expiration.
For both puts and calls, the early-exercise criterion becomes more stringent as the
volatility of the stock increases.
Put-Call Parity:188
The put-call parity relationships discussed previously for the European options do not hold for an
American option. However, it is the case that for American Options:
S 0 - PV[Div] - K CAmer - PAmer S0 - Ke-rT.
187
Based on Figure 11.2 of Derivatives Markets by McDonald, which was computed using Binomial Trees, to be
discussed subsequently.
188
See Appendix 9.A of McDonald, not on the syllabus, discusses parity bounds for American options.
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C(K1 ) C(K2 ).
Buy the K1 Call and Sell the K2 Call (Call Bull Spread)
C(K1 ) - C(K2 ) K2 - K1 .
Sell the K1 Call and Buy the K2 Call (Call Bear Spread)
C(K1) - C(K2 )
K2 - K1
C(K2) - C(K3 )
.
K3 - K2
P(K2 ) P(K1 ).
Sell the K1 Put and Buy the K2 Put (Put Bear Spread)
P(K2 ) - P(K1 ) K2 - K1 .
Buy the K1 Put and Sell the K2 Put (Put Bull Spread)
P(K2 ) - P(K 1)
K2 - K1
189
P(K3 ) - P(K 2)
.
K3 - K2
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192
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If C(K1 ) - C(K2 ) > K2 - K1 , then we can demonstrate arbitrage by buying a call bear spread:
sell the K1 call and buy the K2 call.196
We lend: C(K1 ) - C(K2 ) > K2 - K1 > 0.
If we are dealing with European options, then if at expiration ST K1 , both options expire worthless.
So we have: {C(K1 ) - C(K2 )} erT > 0.
If at expiration K2 > ST K1 , then the option we bought expires worthless.
So we have: {C(K1 ) - C(K2 )} erT - (ST - K1 ) > {K2 - K1 } erT - (ST - K1 ) >
{K2 - K1 } erT - (K2 - K1 ) > 0.
If at expiration K2 < ST, then both options expire in the money.
So we have: {C(K1 ) - C(K2 )} erT + (ST - K2 ) - (ST - K1 ) = {C(K1 ) - C(K2 )} erT - (K2 - K1 ) >
{K2 - K1 } erT - (K2 - K1 ) > 0.
Thus we have demonstrated arbitrage for European calls.
If instead we have American calls, we can deal with the same three cases.
If the call we sold is not exercised early, then the same logic applies as for European calls.197
If instead the option we sold is exercised early at time t, then it must be that St > K1 .
If K2 > St K1 , then the option we bought expires worthless.
So we have: {C(K1 ) - C(K2 )} ert - (St - K1 ) > {K2 - K1 } ert - (St - K1 ) >
{K2 - K1 } ert - (K2 - K1 ) > 0.
If St > K2 , then we can also exercise at time t the call that we bought.198
We then have: {C(K1 ) - C(K2 )} ert + (St - K2 ) - (St - K1 ) = {C(K1 ) - C(K2 )} ert - (K2 - K1 ) >
{K2 - K1 } ert - (K2 - K1 ) > 0.
Thus we have demonstrated arbitrage for American calls.
196
This the reverse of what we did to demonstrate arbitrage if the previous property was violated.
We can wait to expiration to exercise the call we bought and be guaranteed ending with a positive amount.
198
If at time t we can sell the call we bought for more than its exercise value, so much the better for us.
197
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If
If we are dealing with European options, then if at expiration ST K1 , all options expire worthless.
So we have: {C(K2 ) - C(K1 ) - (1 - ) C(K3 )} erT > 0.
If at expiration K2 ST > K1 , then the low strike option we bought expires in the money.
So we have: {C(K2 ) - C(K1 ) - (1 - ) C(K3 )} erT + (ST - K1 ) > 0.
If at expiration K3 ST > K2 , then the low and medium strike options expire in the money.
So we have: {C(K2 ) - C(K1 ) - (1 - ) C(K3 )} erT + (ST - K1 ) - (ST - K2 ) >
C(K2 ) - C(K1 ) - (1 - ) C(K3 ) - (1 - )ST - K1 + K2 >
C(K2 ) - C(K1 ) - (1 - ) C(K3 ) - (1 - )K3 - K1 + K2 =
C(K2 ) - C(K1 ) - (1 - ) C(K3 ) - K3
K2 - K 1
K - K2
- K1 3
+ K2 =
K3 - K 1
K3 - K 1
K2 - K 1
K - K2
- K1 3
+ K2 =
K3 - K 1
K3 - K 1
Note that from the definition of = (K3 - K2 )/(K3 - K1 ), it follows that: K2 - K1 - (1 - )K3 = 0.
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If instead we have American calls, we can deal with the same four cases.
If the call we sold is not exercised early, then the same logic applies as for European calls.200
If instead the option we sold is exercised early at time t, then it must be that St > K2 .
If K3 > St K2 , then the high strike option we bought has an exercise value of zero and we can
exercise the low strike call we bought.201
So we have: {C(K2 ) - C(K1 ) - (1 - ) C(K3 )} ert + (St - K1 ) - (St - K2 ) >
C(K2 ) - C(K1 ) - (1 - ) C(K3 ) - (1 - )St - K1 + K2 >
C(K2 ) - C(K1 ) - (1 - ) C(K3 ) - (1 - )K3 - K1 + K2 =
C(K2 ) - C(K1 ) - (1 - ) C(K3 ) - K3
K2 - K 1
K - K2
- K1 3
+ K2 =
K3 - K 1
K3 - K 1
K2 - K 1
K - K2
- K1 3
+ K2 =
K3 - K 1
K3 - K 1
200
We can wait to expiration to exercise the calls we bought and be guaranteed ending with a positive amount.
If at time t we can sell the calls we bought for more than their exercise value, so much the better for us.
202
If at time t we can sell the calls we bought for more than their exercise value, so much the better for us.
201
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203
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If P(K2 ) - P(K1 ) > K2 - K1 , then we can demonstrate arbitrage by buying a put bull spread:
buy the K1 put and sell the K2 put.207
We lend: P(K2 ) - P(K1 ) > K2 - K1 > 0.
If we are dealing with European options, then if at expiration ST K2 , both options expire worthless.
So we have: {P(K2 ) - P(K1 )} erT > 0.
If at expiration K2 > ST K1 , then the option we bought expires worthless.
So we have: {P(K2 ) - P(K1 )} erT - (K2 - ST) > {K2 - K1 } erT - (K2 - ST) >
{K2 - K1 } erT - (K2 - K1 ) > 0.
If at expiration K1 > ST, then both options expire in the money.
So we have: {P(K2 ) - P(K1 )} erT + (K1 - ST) - (K2 - ST) = {P(K2 ) - P(K1 )} erT - (K2 - K1 ) >
{K2 - K1 } erT - (K2 - K1 ) > 0.
Thus we have demonstrated arbitrage for European puts.
If instead we have American puts, we can deal with the same three cases.
If the put we sold is not exercised early, then the same logic applies as for European puts.208
If instead the option we sold is exercised early at time t, then it must be that St < K2 .
If K2 > St K1 , then the option we bought expires worthless.
So we have: {P(K2 ) - P(K1 )} ert - (K2 - St) > {K2 - K1 } ert - (K2 - St) >
{K2 - K1 } ert - (K2 - K1 ) > 0.
If St < K1 , then we can also exercise at time t the put that we bought.209
We then have: {P(K2 ) - P(K1 )} ert - (K2 - St) + (K1 - St) = {P(K2 ) - P(K1 )} ert - (K2 - K1 ) >
{K2 - K1 } ert - (K2 - K1 ) > 0.
Thus we have demonstrated arbitrage for American puts.
207
This the reverse of what we did to demonstrate arbitrage if the previous property was violated.
We can wait to expiration to exercise the put we bought and be guaranteed ending with a positive amount.
209
If at time t we can sell the put we bought for more than its exercise value, so much the better for us.
208
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If
If we are dealing with European options, then if at expiration ST K3 , all options expire worthless.
So we have: {P(K2 ) - P(K1 ) - (1 - ) P(K3 )} erT > 0.
If at expiration K3 > ST K2 , then the high strike option we bought expires in the money.
So we have: {P(K2 ) - P(K1 ) - (1 - ) P(K3 )} erT + (1 - )(K3 - ST) > 0.
If at expiration K2 > ST K1 , then the high and medium strike options expire in the money.
So we have: {P(K2 ) - P(K1 ) - (1 - ) P(K3 )} erT + (1 - )(K3 - ST) - (K2 - ST) >
P(K2 ) - P(K1 ) - (1 - ) P(K3 ) + S T + (1 - )K3 - K2 >
P(K2 ) - P(K1 ) - (1 - ) P(K3 ) + K1 + (1 - )K3 - K2 =
P(K2 ) - P(K1 ) - (1 - ) P(K3 ) + K1
K3 - K 2
K - K1
+ K3 2
- K2 =
K3 - K 1
K3 - K 1
K2 - K 1
K - K2
+ K1 3
- K2 =
K3 - K 1
K3 - K 1
Note that from the definition of = (K3 - K2 )/(K3 - K1 ), it follows that: K2 - K1 - (1 - )K3 = 0.
2016-MFE,
If instead we have American puts, we can deal with the same four cases.
If the put we sold is not exercised early, then the same logic applies as for European puts.211
If instead the option we sold is exercised early at time t, then it must be that St < K2 .
If K2 > St K1 , then the low strike option we bought has an exercise value of zero and we can
exercise the high strike put we bought.212
So we have: {P(K2 ) - P(K1 ) - (1 - ) P(K3 )} ert + (1 - )(St - K3 ) - (St - K2 ) >
P(K2 ) - P(K1 ) - (1 - ) P(K3 ) + S t + (1 - )K3 - K2 >
P(K2 ) - P(K1 ) - (1 - ) P(K3 ) + K1 + (1 - )K3 - K2 =
P(K2 ) - P(K1 ) - (1 - ) P(K3 ) + K1
K3 - K 2
K - K1
+ K3 2
- K2 =
K3 - K 1
K3 - K 1
K2 - K 1
K - K2
+ K1 3
- K2 =
K3 - K 1
K3 - K 1
We can wait to expiration to exercise the puts we bought and be guaranteed ending with a positive amount.
If at time t we can sell the puts we bought for more than their exercise value, so much the better for us.
213
If at time t we can sell the puts we bought for more than their exercise value, so much the better for us.
214
Not on the syllabus.
212
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Problems:
10.1 (2 points) r = 0%. Stock ABC pays dividends. You own an American call on ABC.
Is it ever optimal to exercise this option before expiration? Briefly explain why.
10.2 (1 point) You have an American put option to exchange one share of Stock A for one share of
Stock B. Neither stock pays dividends. In what circumstances might you exercise this option early?
10.3 (1 point) Which of the following statements about American style options is not true?
A. The option may be exercised at any time during its life.
B. If the underlying stock does not pay a dividend, one should not exercise a call option early.
C. The option is worth at least as much as a similar European style option.
D. The option is worth at least as much as a similar option with more time to expiration.
E. All of A, B, C, and D are true.
10.4 (2 points) On March 1, ABC company stock is worth 20.
However, ABC has announced that on April 1 it will pay a liquidating dividend; ABC will pay its
entire value to its stockholders.
On March 1, compare the values of a European 10-strike call on ABC stock that expires
on March 15 and a similar option that expires on April 15.
10.5 (2 points) r = 0%. Stock ABC pays dividends. You own an American put on ABC.
Is it ever optimal to exercise this option before expiration? Briefly explain why.
10.6 (1 point) An American 85 strike 18 month put is an option on a stock with current price 81 and
forward price of 84. r = 3%.
Which of the following intervals represents the range of possible premiums for this option?
A. [0, 81]
B. [0, 84]
C. [0, 85]
D. [0.96, 84]
E. [0.96, 85]
10.7 (1 point) Which of the following statements is true?
1. A European put is worth at least as much as a similar put with more time until expiration.
2. A European call is worth at least as much as a similar call with more time until expiration.
3. A European option is worth at most as much as a similar American style option.
A. 1
B. 2
C. 3
D. 1, 2, 3
E. None of A, B, C, or D
10.8 (1 point) You have an American call option to exchange one share of Stock A for one share of
Stock B. Neither stock pays dividends. In what circumstances might you exercise this option early?
10.9 (3 points) On January 1 you purchase a 1 year $90 strike American call. r = 6%.
The stock will pay dividends of $1 each on: March 1, June 1, September 1, and December 1.
At what points in time might it be optimal to exercise your call?
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10.10 (2 points) XYZ company goes bankrupt on January 1 and its stock becomes worthless.
On January 1, compare the values of a European 100-strike put on XYZ stock that expires April 1
and a similar option that expires July 1.
10.11 (1 point) You have an American call option with strike price of $100. r = 5% and = 2%.
If the stock price had zero volatility, under what circumstances should you exercise this option early?
10.12 (2 points) r = 6%.
Consider otherwise similar American and European options on a stock that does not pay dividends.
Which of the following could be a graph of the option premiums as a function of the initial stock price,
holding everything else constant?
In each case, the American option premium is shown as dashed.
C
25
C
20
20
15
15
10
10
5
A.
5
B.
90
100
110
S0
120
90
100
110
S0
120
90
100
110
S0
120
P
20
15
15
10
10
C.
90
100
110
S0
120
D.
E. None of A, B, C, or D
10.13 (2 points) Briefly discuss early exercise of American options if the stock has a volatility of
zero, = 0, in other words if the future price of the stock were deterministic rather than random.
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10.14 (1 point) An American 95 strike 3 year call is an option on a stock with current price 90 and
forward price of 100. r = 5%. Determine the width of the range of possible prices of this option.
A. 84
B. 86
C. 88
D. 90
E. 92
10.15 (4 points) Use the following information:
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10.24 (8 points) Consider European and American options on a stock. You are given:
(i) All options have the same strike price of 50.
(ii) All options expire in 2 years.
(iii) The continuously compounded risk-free interest rate is 7%.
(iv) Dividends are paid at the continuously compounded rate of 3%.
For each option, graph the area of possible premiums as a function of the current stock price.
Put the possible stock prices on the horizontal axis, and put the possible option premiums on the
vertical axis.
(a) American Call
(b) European Call
(c) American Put
(d) European Put
10.25 (1 point) On January 1, you purchased an American put option on Stock ABC, with a strike
price of $100 and an expiration date of December 31. Stock ABC pays no dividends.
During the first half of the year, the stock price for ABC stock fell rapidly, and it stood at $60 on
July 1. You expect a "market correction," with the stock price increasing to about $80 by year end.
If you exercise the option on July 1, you will have a net payoff of $40.
If you wait until December 31, you expect to gain only $20. What ought you to do?
10.26 (CAS5B, 11/91, Q.62) (1 point)
The difference between an European and an American option is:
A. A European option is an specific form of a call option while an American option is a specific form
of a put option.
B. A European option can be exercised only at the maturity date of the option where an American
option can be exercised at any time up to and including the maturity date of the option.
C. A European options contains a specific strike price but an American option does not.
D. A European option can be exercised on or before the maturity date and an American option can
be exercised only on one particular day.
E. None of the above.
10.27 (CAS5B, 11/91, Q.65) (1 point)
Which of the following statements about puts and calls are true?
1. When a stock does not pay dividends, an American call is always worth more alive than dead.
2. An American put is always more valuable than a European put.
3. The Black-Scholes formula can be used to value a European put.
A. 1
B. 1, 2
C. 1, 3
D. 2, 3
E. 1, 2, 3
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10.28 (CAS5B, 11/93, Q.13) (1 point) Suppose that just after-you buy an American put and an
European put on a stock, the stock value drops to zero. The effective annual risk-free rate is 10%.
After the drop, the difference in value between the American put and the European put on the stock
is $50. Assume that the term for both options is one year and that they have the same strike price.
In what range does the strike price fall?
A. Less than $450
B. At least $450, but less than $550
C. At least $550, but less than $650
D. $650 or more
E. Cannot be answered from the information given.
10.29 (IOA 109 Specimen Exam 5/99, Q.5) (3.75 points) Draw a diagram to show bounds
(ignoring transaction costs) on the possible values of an American call option as a function of the
price of the underlying security. The bounds illustrated should be independent of any model for the
price process followed by the underlying security. You should explain the rationale behind the
bounds shown.
10.30 (CAS5B, 11/99, Q.15) (1 point)
For which of the following options might it be rational to exercise before maturity?
1. American put on a dividend-paying stock
2. American put on a non-dividend-paying stock
3. American call on a dividend-paying stock
A. 1
B. 3
C. 1, 2
D. 2, 3
E. 1, 2, 3
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I.
II.
=S
=S
100
95.12
= S - 95.12
= S - 100
S
100
100
95.12
95.12
III.
IV.
= 100 - S
= 95.12 - S
100
95.12
Match the option with the shaded region in which its graph lies.
If there are two or more possibilities, choose the chart with the smallest shaded region.
European Call
American Call
European Put
American Put
(A)
(B)
(C)
(D)
(E)
I
II
II
II
II
I
I
I
II
II
III
IV
III
IV
IV
III
III
III
III
IV
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Solutions to Problems:
10.1. For the American call option, dividends on the stock are the reason why we want to receive
the stock earlier. With the interest rate equal to zero, we do not have the benefit of earning interest
on the strike, which is normally a reason for waiting to exercise the call. However, there is another
benefit to waiting to exercise the call, the insurance protection against the stock price moving below
the strike price. We will not exercise the option if it is out-of-the-money. Therefore, there may be
circumstances in which we will early exercise, but we will not always early exercise.
Comment: Similar to question 9.13 in Derivatives Markets by McDonald.
10.2. The underlying asset is Stock A, and the strike consists of Stock B. As Stock B does
not pay a dividend, the interest rate on Stock B is zero. We will therefore never early exercise the
put option, because we cannot receive earlier any benefits associated with holding Stock B there
are none. As Stock B does not pay dividends, we are indifferent between holding the option and
the stock.
Comment: Similar to question 9.14 in Derivatives Markets by McDonald.
10.3. D. Let us compare an option with three years to expiration to a similar option with only two
years to expiration. If we decide to always exercise the first option within two years, then its value is
that of the second option. So an American style option is worth at least as much as a similar option
with less time to expiration.
10.4. The call that expires March 15 will have a positive payoff provided the stock price is more
than 10. This seems likely. In any case, this call premium is positive
Once the liquidating dividend is paid on April 1, ABC stock will become worthless.
Even though one would like to early exercise the call that expires April 15, we cannot since it is
European, rather than American. By the time we can exercise this call, the option to buy ABC stock
at 10 will not be used; this call expires worthless.
In this situation, the call that expires March 15 is worth more than the call that expires April 15.
Comment: An example of how even though the premium of a European call on a dividend paying
stock usually increases with time until expiration, this is not always true.
10.5. For the American put option, when the interest rate is zero, no interest on the strike price is
lost by waiting until maturity to exercise. We still have a volatility benefit from waiting. Therefore, we
should never use the early exercise feature of the American put option.
Comment: If the interest rate is zero, then an American put is worth the same as a European put.
Similar to question 9.13 in Derivatives Markets by McDonald.
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10.11. Since = 0, the implicit insurance protection against the stock price moving below the strike
price is zero. Therefore, it is optimal to exercise early whenever the dividends gained by exercising
early exceed the interest on the strike price. S > r K. S > (r/)K = $250.
Exercise early when S > $250.
Comment: See Section 11.1 of Derivatives Markets by McDonald.
10.12. D. Since there are no dividends, the American call is worth the same as the European call,
eliminating A and B.
With r > 0, the American put is worth more than the European put.
As the stock price gets smaller, it is more likely to be advantageous to exercise early, and the
difference between the American and European put premiums increases, as in graph D.
Comment: For a very high initial stock price, both the European and American puts would be
virtually worthless; as the initial stock price approaches infinity, the difference in these put premiums
approaches zero. For a very low initial stock price, one would probably exercise the American put
immediately for an immediate payoff of K - S0 , while the payoff on the European put would take
place at time T. As the initial stock price approaches zero, the American put premium approaches
K, the European put premium approaches Ke-rT, and the difference in these put premiums
approaches: K - Ke-rT.
10.13. If = 0, then the implicit insurance protection is zero.
Thus for an American call, we would exercise early if the value of the dividends gained is greater than
the value of the interest on the strike price that would be lost. We would exercise an American call
early if: S > rK S > rK/.
For an American put, we would exercise early if the value of the dividends lost is less than the value
of the interest on the strike price that would be gained. We would exercise an American put early if:
S < rK S < rK/.
Comment: See Section 11.1 of Derivatives Markets by McDonald.
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Thus this lower bound on P is: 1.200 - X e - 0.12 for 1.353 X 0.8839 .
0 for X 1.353
Area of
Possible
Premiums
1.3 - X
0.4161
1.2 - X Exp[-0.12]
0
0
0.8839
1.353
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10.20. If it is optimal to exercise an American call early, and dividends are paid at discrete times,
then it is best to exercise right before the payment of a (large) dividend.
So, it might be optimal to exercise this call at expiration, or in one month (just before the payment of
that dividend), or in four months (just before the payment of that dividend).
However, if K{1 - exp[-r(T- t)]} is greater than the present value of the future dividends that will be
paid until the call expires, then it is better to wait rather than exercise early.
At one month: K{1 - exp[-r(T- t)]} = (70){1 - exp[-(8%)(5/12)} = 2.295.
The present value of future dividends is: 1 + 1 exp[-(8%)(3/12)] = 1.980.
Since 2.295 > 1.980, it is better to wait.
(The benefit from the interest on the strike price exceeds the benefit of exercising early and getting
the stock dividends.)
At four months: K{1 - exp[-r(T- t)]} = (70){1 - exp[-(8%)(2/12)} = 0.927.
The present value of future dividends is 1 > 0.927.
So it may be better to exercise early.
It may be optimal to exercise in four months (just before the ex-dividend date) and in six
months (at expiration.)
Comment: Whether it is optimal to exercise early at four months would depend on the stock price
then; for a sufficiently high stock price, it would make sense to exercise early the call.
If we do not exercise in four months, then it is optimal to wait to expiration; we would then exercise at
expiration if the call were in-the-money.
2016-MFE,
0 for S 95.12
Thus this lower bound on C is: S e - 0.1 5 - 81.87 for 130.16 S 95.12 .
C=S
100
Area of
Possible
Premiums
C = S - 100
30.16
C = S exp[-0.15] - 81.87
0
0
95.12
130.16
200
2016-MFE,
10.22. The put premiums must increase as the strike price increases, therefore: 28 P(60) 7.
The absolute difference in the premiums can be at most the difference in the strikes.
Thus P(60) - P(50) 60 - 50. P(60) - 7 10. P(60) 17.
Also, P(80) - P(60) 80 - 60. 28 - P(60) 20. P(60) 8.
In addition by convexity, P(60) (2/3)(7) + (1/3)(28) = 14.
Combining all of the restrictions, 14 P(60) 8.
10.23. B. In order for the American Call to be worth more than the European Call it must be
optimal to early exercise at some point in time.
If it is optimal to exercise an American call early, and dividends are paid at discrete times, then it is
best to exercise right before the payment of a (large) dividend.
However, if K{1 - exp[-r(T- t)]} is greater than the present value of the future dividends that will be
paid until the call expires, then it is better to wait rather than exercise early.
At two months: K{1 - exp[-r(T- t)]} = (100){1 - exp[-(7%)(10/12)]} = 5.666.
The present value of future dividends is:
D {1 + exp[-(7%)(3/12)] + exp[-(7%)(6/12)] + exp[-(7%)(9/12)]} = 3.8971D.
So it would be better to wait to exercise unless: 3.8971D > 5.666. D > 1.45.
At five months: K{1 - exp[-r(T- t)]} = (100){1 - exp[-(7%)(7/12)]} = 4.001.
The present value of future dividends is:
D {1 + exp[-(7%)(3/12)] + exp[-(7%)(6/12)]} = 2.9483D.
So it would be better to wait to exercise unless: 2.9483D > 4.001. D > 1.36.
At eight months: K{1 - exp[-r(T- t)]} = (100){1 - exp[-(7%)(4/12)]} = 2.306.
The present value of future dividends is: D {1 + exp[-(7%)(3/12)]} = 1.9827D.
So it would be better to wait to exercise unless: 1.9827D > 2.306. D > 1.16.
At eleven months: K{1 - exp[-r(T- t)]} = (100){1 - exp[-(7%)(1/12)]} = 0.582.
The present value of future dividends is: D.
So it would be better to wait to exercise unless: D > 0.582.
Thus it is possible that it will be optimal to exercise early at some point in time, provided D > 0.58.
Comment: In this type of setup with dividends of equal size, the key comparison is when the last
dividend is paid.
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Area of
Possible
Premiums
C=S
C = S - 50
62.59
C = 0.942 S - 43.47
46.15
112.59
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(b) Since a European call can only be exercised at expiration: PV0,T[F0,T] CEur.
Thus PV0,T[F0,T] CEur (PV0,T[F0,T] - PV0,T[K])+.
0.942S0 CEur (0.942S0 - 43.47)+.
The lower bound is zero for S0 < 46.15.
For S0 > 46.15, the lower bound is: 0.942S0 - 43.47.
Thus, we get the following graph of possible premiums of the European Call:
C
150
C = 0.942 S
Area of
Possible
Premiums
100
C = 0.942S - 43.47
50
46.15
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Area of
Possible
Premiums
50 - S
50
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Area of
Possible
Premiums
43.47 - 0.942 S
46.15
Comment: Similar to MFE Sample Exam, Q.26.
10.25. If the market consensus agreed with you about the future behavior of ABC stock, then the
price of the stock on July 1 would not be $60.
What you should do is see what the put is selling for on July 1. If the put is selling for more than $40
you should sell it; otherwise you should exercise the put on July 1 for a $40 payoff.
10.26. B.
10.27. E. All are true. Statement #1 is another way of saying that i the absence of dividends it is
never optimal to exercise an American option prior to expiration.
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10.28. C. A market price of $0 implies that the stock will not rise in value in the future. (A market
price of $0 may result when the firm declares bankruptcy and closes its doors, with no intention of
reorganizing.) The holder of the American put option can exercise the option any time between the
purchase date and the expiration date. Since the market value of the stock will remain $0 during the
entire period, the gain from the exercising the option is the same no matter when it is exercised: the
gain is the strike price. The earlier the put option is exercised, the more time the owner has to invest
the proceeds. Thus the holder of the American put will exercise it immediately, with payoff K.
In contrast, the European put will be exercised in one year; the present value of the payoff is K/1.1.
Thus: K - K/1.1 = 50. K = 550.
10.29. The underlying share price is an upper bound because if the call were priced higher than the
share it would be possible to sell the call and buy the share to make a risk free immediate profit.
The value of the call must also be greater than zero and greater than the share price less the present
value of the strike price (exercise price) discounted at the risk free rate. If the call were priced less
than this it would be possible to make a risk free profit by buying the call, selling the share and
investing the discounted strike price (exercise price) at the risk free rate.
Where X is the strike price (exercise price):
Comment: The bounds would be the same if it were a European rather than American call.
If there are dividends paid on the stock, then C S - X exp[-r(t - t)] - PV[Div.].
10.30. E. One could exercise early in any of the given cases. One should not exercise before
maturity an American call on a non-dividend-paying stock.
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