Q 8.

25
The price of a stock is $40. The price of a one-year European put option on the stock
with a strike price of $30 is quoted as $7 and the price of a one-year European call
option on the stock with a strike price of $50 is quoted as $5. Suppose that an investor
buys 100 shares, shorts 100 call options, and buys 100 put options. Draw a diagram
illustrating how the investors profit or loss varies with the stock price over the next year.
How does your answer change if the investor buys 100 shares, shorts 200 call options,
and buys 200 put options?
i. Draw a diagram illustrating how the investors profit or loss varies with the stock
price over the next year.
Initial outlay = -$4,000 + $500 - $700 = -$4,200
If an investor buys 100 shares, shorts 100 call options, and buys 100 put options:
Profit ($)

$500

Long 100 shares

Short 100 call options

Stock Price
$30

-$700

$40

$50

Long 100 put options

Stock Price
range
S<30
30S<40
40S<50
S50

Payoff from long Payoff from short

put options
call options
30-ST
0
0
0
0
0
0
50-ST

Payoff from
long shares
ST-40
ST-40
ST-40
ST-40

Total
Payoff
-10
ST-40
ST-40
15

Profit
-52
ST-82
ST-82
-32

When ST>50, the loss of the short 100 call options will be covered by the profit of
long 100 shares and when ST<30, the long 100 put options will cover the loss of long
100 shares.
ii. How does your answer change if the investor buys 100 shares, shorts 200 call
options, and buys 200 put options?
Initial outlay = -$4,000 + $1000 - $1,400 = -$4,400
If an investor buys 100 shares, shorts 200 call options, and buys 200 put options:
Profit ($)
Long 100 shares

$1000

Short 200 call options

Stock Price
$30

-$1400

Stock Price

Payoff from long put

$40

$50

Long 200 put options

Payoff from short

Payoff from

Total

Profit

range
S<30
30S<40
40S<50
S50

options
30-ST
0
0
0

call options
0
0
0
50-ST

long shares
ST-40
ST-40
ST-40
ST-40

Payoff
-10
ST-40
ST-40
15

-52
ST-82
ST-82
-32

When ST>50, the loss of the short 100 call options will be covered by the long 100 shares
which leaves the remaining short 100 call options naked and this will result in greater
loss. When ST<30, the loss of the long 100 shares will be covered by the long 100 put
options which leaves the remaining long 100 put options naked and this will result in
greater profit.

Question 9.22

Put- Call Parity

C + Xe-rt = p + So D
3 + 20e -0.1 * 0.25 = 3+19-1e 0.1*0.0833
$22.51 > $21.01
Difference = $1.50
Put option undervalued by $1.50
Today
1)
2)
3)
4)

Buy the put option (undervalued). Premium paid = $3

Buy the stock ( price paid =$19)
Sell the call option (premium received = $3)
Borrow $19
a. Borrow $18 for 3 month
b. Borrow $1 for 1 month

3 month later
Sale of stock (fixed at $20)
Repayment of loan:
18e0.1*0.25
1e 0.1*0.0833
Dividend received
NP at month 6
PV of net profit

Q 11.16

= 18.4557
= 1.0084
(1.00)

18.4641
1.5354
1.50

A stock price is currently $50. It is known at the end of six months it will either be $60 or
$42. The risk-free rate of interest with continuous compounding is 12% per annum.
Calculate the value of a six-month European call option on the stock with an exercise
price of $48. Verify that no-arbitrage arguments and risk-neutral valuation arguments
give the same answer.
Given X= $48,
Risk-neutral valuation:
u=

$60
= 1.2
$50

d=

$42
= 0.84
$50
0.12

e rT d
12
0.84 = 0.6162
p=
= e
ud
1.2 0.84

1 p = 1 0.6162 = 0.3838
Node
B

Stock Price
$50 x 1.125 = $45

$50 x 0.875 = $42

$50

Option Value
fu = max(S-X,0)
= max(60-48,0)
= 12
fd = max(S-X,0)
= max(42-48, 0)
=0
f = e rT [pfu + (1-p)fd]
6

= e 0.1212 [0.6162(12) + 0.3838(0)]

= 6.96
Verifying no-arbitrage arguments & risk-neutral valuation
The riskless portfolio is:
Long: shares
Short: 1 call option

$50

$60 - 12

$42 - 0

The portfolio is riskless when: 60 12 = 42

18 = 12
= 0.6667, the value of the portfolio
The value of portfolio is 0.6667 despite of whether stock price moves up to $60 or
down to $42
Long: 0.6667 shares
Short: 1 call option
The value of the portfolio in 6 months is: 60 12 = 60(0.6667) 12
= 28
Given r = 12%,
6

The value of the portfolio today is: 28 e 0.1212 = 26.37

The value of the stock today = $50
Option price denoted = f
The value of the portfolio today is:
50 x 0.6667 f = 26.37
f = 6.96
Thus, the risk-neutral valuation and no-arbitrage arguments give the same answer,
which are 6.96.
Question 13.20

So=0.75
K=0.75
r=0.07
rf=0.09
T=0.75
Volatility= 0.04
Value of Call Option
Fo = 0.75*e(0.07-0.09)0.75
= 0.7388
D1 = [ln(0.7388/0.75) + 0.04*0.75/2] / 0.04*0.75
= -0.4162
D2 = 0.4162-0.04*0.866
= -0.4508
N(D1) = 0.3386
N(D2) = 0.3261
C=e-0.07*0.75 [0.7388*0.3386 0.75*0.3261]
C= 0.0053
Put Call Parity
0.0053+0.75e-0.07*0.75 = p + 0.75e-0.09*0.75
p=0.7169-0.9347
p=0.0159

Calculation of VaR

- Standard deviation of the change in value of the investment in gold per day is
$300,0000.018=$5,400
- Standard deviation of the change in value of the investment in silver per day is
$500,0000.012=$6,000
- Standard deviation of the change in the portfolio value per day is therefore
(5400) 2 (6000) 2 2 * 0.6 * 5400 * 6000

= 10,200

Thus one day 97.5% VaR is therefore:

10200*1.96=19,992
The 10-day 97.5% VaR is
10

* 19,992= 63,220.25

Benefits of Diversifications
Gold: one day 97.5% VaR = 1.96*5400=10,584
10-day 97.5% VaR = 10584*

10

= 33,469.55

Silver: one day 97.5% VaR = 1.96*6000 = 11,760

10-day 97.5% VaR = 11,760*

10

= 37,188.39

Portfolio: 10-day 97.5% VaR is

10

* 19,992= 63,220.25

Thus, (33,469.55+37,188.39)- 63,220.25=7,437.69

Therefore, we are 97.5% certain that we will not lose more than $ 63,220.25497 in the
next 10 days and the reduction through diversification is $ 7,437.69.