Solutions to Homework 6

FM 5021 Mathematical Theory Applied to Finance

8.1 An investor buys a European put on a share for $3. The stock price is $42 and the strike price is $40. Under what circumstances does the investor make a prot? Under what circumstances will the option be exercised? Draw a diagram showing the variation of the investors prot with the stock price at the maturity of the option. The investor makes a prot if the stock price on the expiration date is less than $37, because the gain from exercising the option is greater than $3. Taking into account the initial cost of the option ($3), the prot will be positive. The option will be exercised if the stock price is less than $40 on the expiration date. Below is the graph of the investors prot as a function of the stock price at the maturity of the option.

8.2 An investor sells a European call on a share for $4. The stock price is $47 and the strike price is $50. Under what circumstances does the investor make a prot? Under what circumstances will the option be exercised? Draw a diagram showing the variation of the investors prot with the stock price at the maturity of the option. The investor makes a prot if the price of the stock is below $54 on the expiration date. If the stock price is below $50, the option will not be exercised, and the investor makes a prot of $4 (the price that he received for the option). The option is exercised when the stock price is greater than $50 on the expiration date. If the stock price is between $50 and $54, the option is exercised and the investor makes a prot between $0 and $4. Below is the graph of the investors prot as a function of the stock price at the maturity of the option.

8.4 Explain why brokers require margins when the clients write options but not when they buy options. When an investor buys an option, he must pay it upfront. There are no future liabilities and, therefore, no need for a margin account. When an investor writes an option, there are potential future liabilities. To protect against the risk of a default, margins are required. 8.11 Describe the terminal value of the following portfolio: a newly enteredinto 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. Show that the European put option has the same value as a European call option with the same strike price and maturity. The terminal value of the long forward contract is ST F0 , where ST is the price of the asset at maturity and F0 is the price of the asset at the time the portfolio is set up. The terminal value of the European put option is max(F0 S, 0). The terminal value of the portfolio is, therefore, ST F0 + max(F0 S, 0) = max(0, ST F0 ). Note that this is the same as the terminal value of a European call option with the same maturity as the forward contract and an exercise price equal to F0 . Thus, the forward contract plus the put option is worth the same as a call option with the same strike price and time to maturity as the put option. Since the forward contract is worth zero at the time the portfolio is set up, the European put option is worth the same as the European call option at the time the portfolio is set up. 8.13 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. The holder of an American option has all the rights the holder of a European option does and even more (exercise prior to maturity). Therefore, the American option must be worth 2

at least as much as the European option. 8.14 Explain why an American option is always worth at least as much as its intrinsic value. The holder of an American option has the right to exercise it immediately. The American option must thus be worth at least as much as its intrinsic value. If it were not, an arbitrageur could lock in a prot by buying the option and exercising it immediately. 8.21 Explain why the market makers bid-oer spread represents a real cost to options investors. A fair price for the option can reasonably be assumed to be half way between the bid and oer price quoted by a market maker. An investor typically buys at the market makers oer and sells at the market makers bid. Each time he makes this there is a hidden cost equal to half the bid-oer spread. 9.1 List the six factors that aect stock option prices. The six factors aecting the price of a stock option are: 1. The current stock price, S0 . 2. The strike price, K . 3. The time to expiration, T . 4. The volatility of the stock price, . 5. The risk-free interest rate, r. 6. The dividends expected during the life of the option. 9.2 What is a lower bound for the price of a 4-month call option on a nondividend-paying stock when the stock price is $28, the strike price is $25, and the risk-free interest rate is 8% per annum? A lower bound for the options price is $28 $25e0.08 12 = $3.66. 9.3 What is a lower bound for the price of a 1-month European put option on a non-dividend-paying stock when the stock price is $12, the strike price is $15, and the risk-free interest rate is 6% per annum? A lower bound for the options price is $15e0.06 12 $12 = $2.93. 9.8 Explain why the arguments leading to put-call parity for European options cannot be used to give a similar result for American options. When early exercise is not possible, two portfolios that are worth the same at time T must be worth the same at earlier times. When early exercise is possible, the same argument does not hold. Suppose, for example, that P + S > C + KerT . This does not necessarily lead to arbitrage opportunities. If we buy the call, short the put, and short the stock, we 3
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cannot be sure of the result because we do not know when the put will be exercised. 9.13 Give an intuitive explanation of why the early exercise of an American put becomes more attractive as the risk-free rate increases and volatility decreases. The early exercise of an American put option is attractive when the interest earned on the strike price is greater than the insurance element lost. When interest rates increase, the value of the interest earned on the strike price increases making early exercise more attractive. When volatility decreases, the insurance element is less valueable. This makes early exercise more attractive. 9.18 Prove the result in equation (9.4). (Hint: For the rst part of the relationship, consider (a) a portfolio consisting of a European call plus an amount of cash equal to K , and (b) a portfolio consisting of an American put option plus one share.) Since P p, from the put-call parity p + S0 = c + KerT we obtain that P c + KerT S0 and since c = C (because it is never optimal to exercise an American call option on a nondividend paying stock prior to expiry), P C + KerT S0 , i.e. C P S0 KerT . Consider now the following two portfolios: Portfolio (a): One European call option plus and amount of cash equal to K . Portfolio (b): One American put option plus one share. Both options have the same exercise price and expiration date. Assume that the cash in portfolio (a) is invested at the risk-free interest rate. If the put option is not exercised early portfolio (b) is worth ST + max(K ST , 0) = max(K, ST ) at time T . Portfolio (a) is worth max(ST K, 0) + KerT = max(ST , K ) K + KerT at time T . Therefore, portfolio (a) is worth more than portfolio (b). Suppose next that the put option in portfolio (b) is exercised early, say at time Tearly . This means that portfolio (b) is worth K at time Tearly . However, portfolio (a) is worth at least KerTearly at time Tearly . Thus, portfolio (a) is worth at least as much as portfolio (b) in all circumstances. Hence c + K P + S0 . 4

Since c = C , C + K P + S0 , i.e., C P S0 K. Therefore, we have established (9.4) S0 K C P S0 KerT .