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Spring 2015
Homework 1: Chapters 1 through 3
Due Monday, 01/28/2015
1. Read Chapters 1-3 in the textbook.
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, calculate the strike price, K.
(A) 449
(B) 452
(C) 480
(D) 559
(E) 582
Solution:
Question 2 from SOA exam: edu-2014-10-exam-fm-ques.pdf
This is putcall parity (McDonald, page 70):
Call(K, T ) Put(K, T ) = PV(F0,T K)
66.59 18.64 = 500 Ke0.06
K = (500 66.59 + 18.64)e0.06
= 480
Answer: C
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.
Solution:
Lock in the . . . means you want to go long. Buy the call and sell the out. The forward price is F = S0 (1 + r) =
1, 050. Since you want to buy at a price below the forward price, you have to pay something now. (You can buy
at the forward price 1050 for 0 now.) You can determine answer the correct choice now (E). Use putcall parity
to find the cost, if you like.
Call(K, T ) Put(K, T ) = PV(F0,T K)
= (1, 050 1, 025) (1.05)1
= 23.81
Answer: E
Page 2
4. The current stock price is 40, and the effective annual interest rate is 8%. These are the current prices for 1-year
European call options on the stock:
Strike
35
40
45
Price
9.12
6.22
4.08
Assuming that all call positions being compared are long, at what 1-year stock price range does the 45-strike call
produce a higher profit than the 40-strike call, but a lower profit than the 35-strike call?
(A) S1 < 38.13.
(B) 38.13 < S1 < 40.44.
(C) 40.44 < S1 < 42.31.
(D) S1 > 42.31.
(E) There is no price for S1 at which this situation occurs.
Solution:
Draw the profit diagrams.
Profit
20
10
10
20
30
40
50
60
Stock Price
s
-10
-20
Page 3
5. Suppose that you short one share of a stock index for 50, and that you also buy a 60-strike European call option
that expires in 2 years for 10. Assume the effective annual interest rate is 3%.
If the stock index increases to 75 after 2 years, what is the profit on your combined position, and what is an
alternative name for the call in this context?
Profit
Name
(A) 22.64
Floor
(B) 17.56
Floor
(C) 22.64
Cap
(D) 17.56
Cap
(E) 22.64
Solution:
The short stock and long call combination is a cap (choice C or D).
Profit = 50(1.03)2 75 + (75 60) 10(1.03)2
|
{z
} |
{z
}
short stock
long call
= 17.56
Answer: D
6. The current price of a non-dividend paying stock is 40 and the continuously compounded risk-free rate of return
is 8%. You are given that the price of a 35-strike call option is 3.35 higher than the price of a 40-strike call option,
where both options expire in 3 months.
How much does the price of an otherwise equivalent 40-strike put option exceed the price of an otherwise equivalent 35-strike put option?
Solution:
Use put-call parity.
Put(K1 , T ) Put(K2 , T ) = Call(K1 , T ) PV(F0,T K1 ) Call(K2 , T ) PV(F0,T K2 )
= Call(K1 , T ) Call(K2 , T ) + (K1 K2 )erT
= 3.35 + 5e0.08(0.25) = 1.55
Answer: 1.55
7. Which of the following positions have an unlimited loss potential from adverse price movement in the underlying
asset, regardless of the initial premium received?
I. Short 1 forward contract
II. Short 1 call option
III. Short 1 put option
(A) I only.
(B) I and II only.
(C) I and III only.
(D) II and III only.
(E) I, II, and III.
Page 4
Solution:
Only the short put has a limited loss potential.
Answer: B
Page 5
Page 6
Strike Price
90
100
110
80
90
100
110
120
130
140
-5
-10
3.36
S1 90
S + constant
90
S1 100
1
Profit =
3.36
Now scan the other choices. (A), (B), and (E) have exactly four positions that payoff 0 or a linear function of S1
so it is possible for them to net to zero for large or small values of S1 . But (D) is suspicious because it has five
functions. So take a closer look at (D) with S1 90. In this range the call is out of the money, so you have the
stock, a long put, and short 2 puts. The long put is a floor for the stock so in this range they sum to a constant. So
being short 2 puts means the slope is 2 in this range. Here is the formula for S1 90:
Profit = (100 14.63 6.81 + 2(1.93)) e0.05 + S1 + 0 + 110 S1 2(100 S1 )
= constant + 2S1
Answer: D
Page 7
For completeness, here are the formulas for the other choices.
Consider (A).
[0.24 6.81 + 2(1.93)]e0.05 +(90 S1 )+ + (110 S1 )+ 2(100 S1 )+
for S1 90 or S1 110
3.36
= 3.36 + S1 90
for 90 S1 100
for S1 90 or S1 110
3.36
= 3.36 + S1 90
for 90 S1 100
[100 0.24 2.17 + 2(6.80)]e0.05 +S1 + (90 S1 )+ + (S1 110)+ 2(S1 100)+
for S1 90 or S1 110
93.36 + 90
= 93.36 + S1
for 90 S1 100
Page 8