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[a]
The option is at the money, so S0 = X = 50.
From put-call parity:
X 50
C =P + S0 =4 + 50 =$5.18
(1 + rf )T
1.10.25
[b]
Since you believe that the stock price will stay in a narrow range of $50, you should bet against
volatility and form a strategy resulting in positive payoffs within that range.
We learnt from the lecture that a Butterfly spread strategy will have that kind of payoff, but it
involves only call options.
A general principal of option investments is: when you buy options (i.e., hold long options), you
bet on volatility (upside price movement for call options, and downside price movement for put
options). For example, a Straddle strategy (one long call + one long put) bets on both sides of
price movement.
So if you are betting against volatility, you should take the opposite sell options. Now lets
look at the strategy of selling a straddle, i.e., a short call plus a short put. Doing so will give you
at time 0 premium income of:
$5.18 + $4 = $9.18
X=50
ST
-50
Hence, the strategy will give you a maximum profit of $9.18 when the stock ends up at $50.
And your profit will decrease when the stock price move away from $50 in either direction
because you have to pay the option buyer in that case. The stock price can move by $9.18 in
either direction before your profits become negative.
[c] &[d]
From put-call parity:
St ct = PV(X) pt
And thus
St = PV(X) pt + ct
So to replicate a stock, you would need to: buy a call, sell (write) a put, and buy a (zero-
coupon) bond (i.e. make a lending). The strike prices of both options and the face value of the
bond should be the same (X), and lets take X = 50.
We can check whether such strategy indeed replicates a stock:
The payoff is as follows:
Position Value at time 0 CF in 3 months
ST X ST > X
Call (long) C = 5.18 0 S T 50
Put (short) P = 4.00 (50 S T) 0
50
Bond (Long) = 48.82 50 50
1.101 / 4
50
Total CP+ = 50.00 ST ST
1.101 / 4
Under no arbitrage condition, the stock price should equal to the cost of its replicating strategy,
i.e., the call premium, minus the put premium, and plus the bond price (the present value of its
face value):
3. An investor who writes a call on an existing portfolio takes a covered call position.
If, at expiration, the value of the portfolio exceeds the exercise price of the call, the
writer of the covered call can expect the call to be exercised, so that the writer of the
call must sell the portfolio at the exercise price. Alternatively, if the value of the
portfolio is less than the exercise price, the writer of the call keeps both the portfolio
and the premium paid by the buyer of the call. The trade-off for the writer of the
covered call is the premium income received versus forfeit of any possible capital
appreciation above the exercise price of the call.
5.
Cost Payoff Profit
a. Call option, X = $190.00 $6.75 $5.00 -$1.75
b. Put option, X = $190.00 3.00 0.00 -3.00
c. Call option, X = $195.00 3.65 0.00 -3.65
d. Put option, X = $195.00 5.00 0.00 -5.00
e. Call option, X = $200.00 1.61 0.00 -1.61
f. Put option, X = $200.00 8.09 5.00 -3.09
7. a. From put-call parity:
X 100
P =C S0 + =10 100 + =$7.65
(1 + rf )T
1.10.25
b. Purchase a straddle, i.e., both a put and a call on the stock. The total cost of
the straddle is $10 + $7.65 = $17.65
10. Note that the price of the put equals the revenue from writing the call, net initial
cash outlays = $38.00
Position ST < 35 35 ST 40 40 < ST
Buy stock ST ST ST
Write call ($40) 0 0 40 - ST
Buy put ($35) 35- ST 0 0
Total $35 ST $40
Profit
$2
$35 $40
-$3
12. a.
Outcome ST X ST > X
Stock ST + D ST + D
Put X ST 0
Total X+D ST + D
b.
Outcome ST X ST > X
Call 0 ST X
Zeros X+D X+D
Total X+D ST + D
The total payoffs for the two strategies are equal regardless of whether S T
exceeds X.
20. a.
Position S T < 190 190 S T 195 S T > 195
Write call, X = $195 0 0 (S T 195)
Write put, X = $190 (190 S T) 0 0
Total S T 190 0 195 S T
Payoff
190 195
ST
c. You break even when either the put or the call results in a cash outflow of
-$1.24. For the put, this requires that:
-$1.24 = $190.00 S T S T = $191.24
For the call, this requires that:
-$1.24 = S T $195.00 S T = $193.76
d. The investor is betting that IBM stock price will have low volatility. This
position is similar to a straddle.
24. The following payoff table shows that the portfolio is riskless with time-T value
equal to $10:
Position S T 10 S T > 10
Buy stock ST ST
Write call, X = $10 0 (S T 10)
Buy put, X = $10 10 S T 0
Total 10 10
Therefore, the risk-free rate is: ($10/$9.50) 1 = 0.0526 = 5.26%
25. a., b.