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# FINS2624 Portfolio

Management
Tutorial 11 Week 12

Problem Set 11
Q1a. Consider the data in the table:

## What is the price of a European call option with the properties as

described in the table?
A.

ct St N d1 Xe r T t N d 2
d1

S
ln t
X

d 2 d1

2

T t
r
2

T t

T t

Problem Set 11
Continued A.

0.352
132
1.5
ln
0.03
2
100
d1
0.9670
0.35 1.5
d 2 0.9670 0.35 1.5 0.5383
N d1 N 0.9670 0.8332

N d 2 N 0.5383 0.7048
ct 132 0.8332 100e 0 .031.5 0.7048
ct 42.60

Problem Set 11
Q1b. What is the price of the corresponding European put option?
A.

p t St Xe r T t ct
p t 132 100e 0.031.5 42.60
pt 6.20

Problem Set 11
Q1c. How would you expect the put and call prices to change if the risk free
interest rate increased to 4%?
A.

Greek letter
Delta,
Theta,
Vega,
Rho,
None

Variable

Call option

Put option

St
t

r
X

Positive
Negative
Positive
Positive
Negative

Negative
(Typically) negative
Positive
Negative
Positive

## For call option:

=+ ve
Call option gives the right to buy stocks at fixed price at time t. Thats a negative CF; we
buy the stocks. We would like to discount it as largely as possible. So higher interest
rate makes the call options more valuable.
For Put option:

= -ve
Put option gives the right to sell stocks at fixed price at time t. Thats a positive CF; we
sell the stocks. We would like to discount it as less heavily as possible. So higher
interest rate makes the put options less valuable.

Problem Set 11
Q1d. Show that, in general, the price of a European put option is:
pt = Xer(T t)N(d2) SN(d1)
A.

pt St Xe r T t ct

pt St Xe r T t St N d1 Xe r T t N d 2
pt St N d1 St Xe r T t Xe r T t N d 2
pt Xe r T t 1 N d 2 St 1 N d1
pt Xe r T t N d 2 St N d1

Problem Set 11
Q1e. You hold 100 put options. What position would you have to take in
the underlying stock in order to be delta neutral?
A.

dp
put N d1 1
dS
put 0.8332 1 0.1668
d
Portfolio (100 0.1668) 16.68
dS

To make the portfolio delta neutral, we need to buy 16.68 stocks ( Delta
hedging). The movement in put values cancelled out by movement in
stocks.

Problem Set 11
Q1f. You hold 100 put options. What position would you have to take
in the call option in order to be delta neutral?
A.

dc
Call N d1 0.8332
dS
Portfolio 0 100 (0.1668) N Call 0.8332
N Call 20.02
To make the portfolio delta neutral need to buy 20.02 call options.

Problem Set 11
Q1g. The market price of the call option is \$42.60. What is the
implied volatility?
A. The market price of the option turns out to be the one that we already
have calculated. Therefore, the implied volatility is the volatility that
we used in the calculation of call option (35%). The B-S formula priced
this option accurately.

Problem Set 11
Q1h. Suppose you would estimate the historical volatility of S to30%.
What implications would that have for the volatility and/or the
Black-Scholes model?
A. Historic volatility is 30%. This does not have to be a contradiction
with Black-Scholes.
In B-S, we assume the volatility is constant for the rest of the life of the
option. If the historic volatility is 30%, it does not necessarily mean that
the volatility for the remaining life of the option would not be 35%. The BS
volatility is forward looking.

Problem Set 11
Q1i. If we accept the assumptions underlying the Black-Scholes
model, what should the implied volatility of a European call
option written on S with a time to expiration of 1.5 years and a
strike price of \$150?
A. We would expect it to be the same. Changes in the strike price is not
expected to change the volatility of the underlying stock.

Problem Set 11
Q1j. Suppose you find that the implied volatility for the option is
actually 40%. What implications would that have for the volatility
and/or the Black-Scholes model?
A.

Something is wrong.
Stock return may not be normally distributed.
transaction cost
something is not clicking
More research needed; how could we make the model more realisticwelcome
you guys to explore more.

Volatility smile: