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EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

EF4420 Derivative Analysis and Advanced Investment Strategies


Problem Set 5

This problem set is to be turned in by Wednesday, March 24th 11:00 pm. Please present your work using
MS Word or PDF and submit online on Canvas. You may use Excel for calculation but the final solution
should be presented in MS Word or PDF.

1. Arbitrage Using Put


Consider a 1-year European put option on a stock. The option has the strike price of $40 and the option
price is $7. The stock will pay no dividend until the option maturity and is currently priced for $30. The
risk-free interest rate is 2%. Is there an arbitrage? If so, find the arbitrage strategy and its profit.

2. Arbitrage Using Put and Call


The price of a non-dividend-paying stock is $19 and the price of a 3-month European call option on the
stock with a strike price of $20 is $1. The risk-free rate is 4% per annum. The price of a 3-month European
put option with a strike price of $20 is $1.7. Is there an arbitrage? If so, find the arbitrage strategy and its
profit.

1 Instructor: Yongjin Kim


EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

3. Convexity of Option Prices


Suppose that c1 , c2 , and c3 are the prices of European call options with the strike prices K1 , K2 , and K3 ,
respectively, where K3 > K2 > K1 and K3 K2 = K2 K1 . All options have the same maturity. Show that

c2 0.5(c1 + c3 )

Hint 1: Consider a portfolio where we long one option with strike price K1 , long one option with strike price
K3 , and short two options with strike price K2 .
Hint 2: Show that the payoff of the portfolio at the option maturity is always positive or zero. Then, we
can deduce the relation among current option prices.

2 Instructor: Yongjin Kim

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