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Tutorial 8

Textbook: Fundamentals of Futures and Options Markets by John C. Hull. Pearson


new International Edition. Ed 8. ISBN number: 978-1-29204-190-2

Note: Questions with * must be covered in tutorial class

Problem 13.8.
A stock price is currently $40. Assume that the expected return from the stock is 15% and its
volatility is 25%. What is the probability distribution for the rate of return (with continuous
compounding) earned over a one-year period?

In this case 015 and 025 . From equation (13.4) the probability distribution for the
rate of return over a one-year period with continuous compounding is:
0.252
0.15 , 0.252
2
i.e.,
(0.11875, 0.252 )
The expected value of the return is 11.875% per annum and the standard deviation is 25.0%
per annum.

Problem 13.15.
A call option on a non-dividend-paying stock has a market price of $250 . The stock price is
$15, the exercise price is $13, the time to maturity is three months, and the risk-free interest
rate is 5% per annum. What is the implied volatility?

In the case c 25 , S0 15 , K 13 , T 025 , r 005 . The implied volatility must be


calculated using an iterative procedure.
A volatility of 0.2 (or 20% per annum) gives c 220 . A volatility of 0.3 gives c 232 . A
volatility of 0.4 gives c 2507 . A volatility of 0.39 gives c 2487 . By interpolation the
implied volatility is about 0.396 or 39.6% per annum.
The implied volatility can also be calculated using DerivaGem. Select equity as the
Underlying Type in the first worksheet. Select Black-Scholes European as the Option Type.

Problem 13.20.*
Show that the BlackScholesMerton formulas for call and put options satisfy putcall
parity.

The BlackScholesMerton formula for a European call option is


c S0 N (d1 ) Ke rT N (d 2 )
so that
c Ke rT S0 N (d1 ) Ke rT N (d 2 ) Ke rT
or
c Ke rT S0 N (d1 ) Ke rT [1 N (d 2 )]
or
c Ke rT S0 N (d1 ) Ke rT N (d 2 )
The BlackScholesMerton formula for a European put option is
p Ke rT N (d 2 ) S0 N (d1 )
so that
p S0 Ke rT N (d 2 ) S0 N (d1 ) S0
or
p S0 Ke rT N (d 2 ) S0 [1 N (d1 )]
or
p S0 Ke rT N (d 2 ) S0 N (d1 )
This shows that the putcall parity result
c Ke rT p S0

Problem 13.26.*
Consider an option on a non-dividend-paying stock when the stock price is $30, the exercise
price is $29, the risk-free interest rate is 5% per annum, the volatility is 25% per annum, and
the time to maturity is four months.
a. What is the price of the option if it is a European call?
b. What is the price of the option if it is an American call?
c. What is the price of the option if it is a European put?
d. Verify that putcall parity holds.

In this case S0 30 , K 29 , r 005 , 025 and T 4 12


ln(30 29) (005 0252 2) 4 12
d1 04225
025 03333

ln(30 29) (005 0252 2) 4 12


d2 02782
025 03333

N (04225) 06637 N (02782) 06096

N (04225) 03363 N (02782) 03904

a. The European call price is


30 06637 29e0054 12 06096 252
or $2.52.
b. The American call price is the same as the European call price. It is $2.52.
c. The European put price is
29e005412 03904 30 03363 105
or $1.05.
d. Put-call parity states that:
p S c Ke rT
In this case c 252 , S0 30 , K 29 , p 105 and e rT 09835 and it is easy to verify
that the relationship is satisfied.
Problem 13.27.*
Assume that the stock in Problem 13.26 is due to go ex-dividend in 1.5 months. The expected
dividend is 50 cents.
a. What is the price of the option if it is a European call?
b. What is the price of the option if it is a European put?
c. Use the results in the Appendix to this chapter to determine whether there are any
circumstances under which the option is exercised early.

a. The present value of the dividend must be subtracted from the stock price. This gives
a new stock price of:
30 05e0125005 295031
and
ln(295031 29) (005 0252 2) 03333
d1 03068
025 03333

ln(295031 29) (005 0252 2) 03333


d2 01625
025 03333

N (d1 ) 06205 N (d2 ) 05645


The price of the option is therefore
295031 06205 29e005412 05645 221
or $2.21.
b. Because
N (d1 ) 03795 N (d2 ) 04355
the value of the option when it is a European put is
29e0054 12 04355 295031 03795 122
or $1.22.
c. If t1 denotes the time when the dividend is paid:
K (1 e r (T t1 ) ) 29(1 e00502083 ) 03005
This is less than the dividend. Hence the option should be exercised immediately before the
ex-dividend date for a sufficiently high value of the stock price.

Additional questions:

Problem 17.11.*
What is the delta of a short position in 1,000 European call options on silver futures? The
options mature in eight months, and the futures contract underlying the option matures in
nine months. The current nine-month futures price is $8 per ounce, the exercise price of the
options is $8, the risk-free interest rate is 12% per annum, and the volatility of silver is 18%
per annum.
The delta of a European futures call option is usually defined as the rate of change of the
option price with respect to the futures price (not the spot price). It is
e rT N (d1 )
In this case F0 8 , K 8 , r 012 , 018 , T 06667
ln(8 8) (0182 2) 06667
d1 00735
018 06667
N (d1 ) 05293 and the delta of the option is
e01206667 05293 04886
The delta of a short position in 1,000 futures options is therefore 4886 .

Problem 17.22.
A banks position in options on the dollareuro exchange rate has a delta of 30,000 and a
gamma of 80 000 . Explain how these numbers can be interpreted. The exchange rate
(dollars per euro) is 0.90. What position would you take to make the position delta neutral?
After a short period of time, the exchange rate moves to 0.93. Estimate the new delta. What
additional trade is necessary to keep the position delta neutral? Assuming the bank did set up
a delta-neutral position originally, has it gained or lost money from the exchange-rate
movement?

The delta indicates that when the value of the euro exchange rate increases by $0.01, the
value of the banks position increases by 0.0130,000 = $300. The gamma indicates that
when the euro exchange rate increases by $0.01 the delta of the portfolio decreases by
001 80 000 800 . For delta neutrality 30,000 euros should be shorted. When the exchange
rate moves up to 0.93, we expect the delta of the portfolio to decrease by
(093 090) 80 000 2 400 so that it becomes 27,600. To maintain delta neutrality, it is
therefore necessary for the bank to unwind its short position 2,400 euros so that a net 27,600
have been shorted. As shown in the text (see Figure 17.8), when a portfolio is delta neutral
and has a negative gamma, a loss is experienced when there is a large movement in the
underlying asset price. We can conclude that the bank is likely to have lost money.