Problem Set 5.- Mechanics of option markets.

5.1. An investor sells a European call option with strike price of K and maturity T and buys a put
with the same strike price and maturity. Describe the investor's position.

Sol. K-ST in all circumstances.

5.2. Describe the terminal value of the following portfolio:· a newly entered-into long forward
contract on an asset and a long position in a European put option on the asset with the same
maturity as the forward contract and a strike price that is equal to the forward price of the asset
at the time the portfolio is set up.

Sol. Show that the European put option has the same value as a European call option with the
same strike price and maturity.

5.3. Explain why an American option is always worth at least as much as a European option on
the same asset with the same strike price and exercise date.

5.4. 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 investor's 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?

Sol. (a) first figure; (b) second figure

 Problem Set 6.- Properties of options

6.1. List the six factors affecting stock option prices.

6.2. What is a lower bound for the price of a four-month call option on a non-dividend paying
stock when the stock price is $28, the strike price is $25, and the risk-free interest rate is 8% per
annum?

Sol. $3.66

6.3. What is a lower bound for the price of a one-month European put option on a nondividend-
paying stock when the stock price is $12, the strike price is $15, and the risk-free interest rate is
6% per annum?

Sol. $2.93

6.4. Give two reasons that the early exercise of an American call option on a non-dividend paying
stock is not optimal. The first reason should involve the time value of money. The second reason
should apply even if interest rates are zero.

Sol. Delaying exercise delays the payment of the strike price. This means that the option holder
is able to earn interest on the strike price for a longer period of time. Delaying exercise also
provides insurance against the stock price falling below the strike price by the expiration date.
Assume that the option holder has an amount of cash K and that interest rates are zero.
Exercising early means that the option holder's position will be worth ST at expiration. Delaying
exercise means that it will be worth max(K, ST) at expiration.

6.5. The price of a non-dividend paying stock is $19 and the price of a three-month European
call option on the stock with a strike price of $20 is $1. The risk-free rate is 4% per annum. What
is the price of a three-month European put option witl1 a strike price of $20?

Sol. $1.80

6.6. The price of a European call that expires in six months and has a strike price of $30 is $2.
The underlying stock price is $29, and a dividend of $0.50 is expected in two months and again
in five months. The term structure is flat, with all risk-free interest rates being 10%. What is the
price of a European put option that expires in six months and has a strike price of $30?

Sol. Put price is $2.51

6.7. You would like to speculate on a rise in the price of a certain stock. The current stock price
is $29, and a three-month call with a strike of $30 costs $2.90. You have $5,800 to invest.
Identify two alternative strategies, one involving an investment in the stock and the other
involving investment in the option. What are the potencial losses and gains from each?

6.8 It is May and a trader writes a September call option with a strike price of $20. The stock
price is $18, and the option price is $2. Describe the trader's cash flows if the option is held
until September and the stock price is $25 at that time.

6.9 Describe the profit from the following portfolio: a long forward contract on an asset and a
long European put option on the asset with the same maturity as the forward contract and
a strike price that is equal to the forward price of the asset at the time the portfolio is set
up.

6.10 What opportunities are open to an arbitrageur in the following situations?

a. A 180-day European call option to buy £1 for $1.97 costs 2 cents.

b. A 90-day European put option to sell £1 for $2.04 costs 2 cents.

Sol. (a) 1.9818-ST, when ST < 1.97; 0.0118, when ST<1.97

(a) ST – 2.0256, when ST > 2.04; 0.0144, when ST<2.04

6.11. The current price of a stock is $94, and three-month European call options with a strike
price of $95 currently sell for $4.70. An investor who feels that the price of the stock will
increase is trying to decide between buying 100 shares and buying 2,000 call options (= 20
contracts). Both strategies involve an investment of $9,400. What advice would you give?
How high does the stock price have to rise for the option strategy to be more profitable?

Sol. More profitable strategy is when stock prices rises above $100.

6.12. True or false? The price of a calls equals the price of a put when the strike price is F.

Sol. True. Look at the value of a forward contract when K = F.