FINA 403 - Derivatives Spring 2013 Assignment 2

Please answer the questions below in a single Excel file (including the written answers) and e-mail your response to me at rmckeon@sandiego.edu by the end of Friday, Mar 8th. Answer each question on a separate sheet in the Excel file. Please save your document as [your last name]_FIN403_assignment2 before submitting it. 1) Use payoff tables to prove the following pricing rules (all options are European and there are NO dividend payments involved): a) Maximum difference (NOTE: the options are on the same asset and have the same time to expiry) C(K1) C(K2) PV(K2 K1), where K2 > K1 P(K2) P(K1) PV(K2 K1), where K2 > K1 b) Put-Call Parity (NOTE: the options are on the same asset and have the same time to expiry and the same strike price) C + PV(K) = P + S0 2) [Unless noted, all options in question 2 are European and there are NO dividend payments involved. All examples assume there are NO costs involved in trading at all.] (CAN HAVE NO ARBITRAGE) a) A Put option which expires in a months time has a strike price of $50 and a premium of $50. The current price of the underlying asset is $10 and the rate of interest for one month is 1%. Can you arbitrage? If so, explain and show how. b) A Put option has a price of $1, a strike price of $40 and there are six months remaining until expiry. The current price of the underlying asset is $37 and the interest rate is 5% per annum. Can you arbitrage? If so, explain and show how. c) A Call option with strike price of $50 is trading in the market at $15. A different Call option, which is on the same asset and has the same time to maturity, but a strike price of $60 has a price of $2. Both options have a year until expiry, the interest rate is 5% per annum, and the current price of the underlying asset is $55. Can you arbitrage? If so, explain and show how.

d) A Call option has a price of $3, a strike price of $30 and 3 months left until expiry. The current price of the underlying asset is $31 and the interest rate is 10% per annum. i) If a Put option on the same asset with the same time to maturity and same strike price is trading at $2.25, can you arbitrage? If so, explain and show how. ii) If a Put option on the same asset with the same time to maturity and same strike price is trading at $1, can you arbitrage? If so, explain and show how. 3) Options which are at-the-money tend to have more time value than options which are in- or out-the-money (see the spreadsheet Time value and moneyness.xlsx which we worked through in class and which is posted on the course website). Why is this true? Provide a full and detailed explanation using examples and/or illustrations. 4) Some commentators state that a covered call strategy and a short put position (often called a naked Put) essentially amount to the same trade since the picture of their P/L profiles at expiry have the same shape. a) using payoff tables, determine the payoffs at expiry for both strategies in different price scenarios. Are the payoffs the same(yes) for the two strategies? b) in a spreadsheet conduct an analysis which compares the returns at expiry on the following two different strategies: i) a covered call strategy where you buy the 100 shares of stock at $30/share and sell an at-the-money call for $3/share (contract size is 100 shares) ii) a naked short put position on the above asset where the put premium is $2.50/share, has a strike price of $30, contract size is 100 shares and the initial margin is 100% (use the margin as the original investment base for calculating returns) [consider the following scenarios for the price of the stock at the option expiry: $0 to $60 in $5 increments] c) What do you conclude about the relative risks/rewards of covered call versus naked short put based on your results in part (b)? 5) Suppose you buy a Put option with strike price of $20 on a stock which is trading in the market at $18 per share. The premium you pay for the Put is $2.80. One week later, the price of the stock has decreased to $17 per share and the premium for the same Put option contract is $4.10. Explain why the option premium increased in as much detail as possible.
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6) As a general rule it is not optimal to exercise a Call option prior to expiry if it is on a stock which is not paying out a dividend during the life of the Call. (text book ch. 3) a) Explain why it is not optimal to exercise such a Call option prior to expiry in your own words. b) Explain why the scheduled payment of a dividend prior to expiry of the Call would negate this general rule. 7) A Bull Spread trade is traditionally set up by trading two different Call options. However, the same basic strategy can also be constructed by trading two Put options. A relevant question for an investor would be: which one of these is cheaper to implement the Bull spread with Calls or Puts? By comparing the payoffs at expiry for the two different ways of setting up a Bull spread, show that the cost of implementing the trade with Call options should always cost more than implementing it with Puts by exactly PV(K2 K1) 8) How would you set up the equivalent of a Protective Put strategy using Call option(s)? -