Portfolio Management

PROBLEM SET 10
BY FLORENT ROUXELIN

2015-2017 Florent Rouxelin ALL RIGHTS RESERVED. Please do not circulate.

PS9 - Florent Rouxelin 14/10/2017

 Lecture Summary
2

Call Option: The buyer of the call option has the right, but not the
obligation to buy an agreed quantity of a financial instrument (the
underlying) from the seller of the option at a certain time (the
expiration date) for a certain price (the strike price)

Put Option: the owner of the put has the right, but not the obligation,
to sell an asset (the underlying), at a specified price (the strike), by a
predetermined date (the maturity) to a given party (the buyer of the
put)

Put options are most commonly used in the stock market to protect
against the decline of the price of a stock below a specified price

PS10 - Florent Rouxelin 14/10/2017

 Payoff Put/Call options
3

PS10 - Florent Rouxelin 14/10/2017

 Premium/Price/Value/Payoff ?
4

Options: Key concepts

Option Premium
The price of an option. Price, premium and value are strictly equivalent words for options
= +
Intrinsic Value: Measures the exercise value of an option
Long the option pay the premium
Short the option receive the premium

Option price/value/premium is calculated with Black-Scholes formula and Put-Call Parity

Option payoff: The payoff is received at MATURITY of the option

= , 0
= , 0

X= Strike
= Stock price at MATURITY of the option

PS10 - Florent Rouxelin 14/10/2017

 Difference between profit and payoff diagram?
5

Both diagram look at the profit/payoff of the option AT MATURITY!

Payoff diagram takes ONLY into account the payoff of the option:

= , 0
= , 0

X= Strike
= Stock price at MATURITY of the option

Profit diagram takes into account the payoff at maturity + future value
(maturity) of the premium/price/value of the option

PS10 - Florent Rouxelin 14/10/2017

 Difference between Payoff and Profit
6

PS10 - Florent Rouxelin 14/10/2017

 Put-Call Parity
7

PutCall parity: defines a relationship between

the price of a European call option and European put
option, both with the identical strike price and
maturity, namely that a portfolio of a long call option
and a short put option is equivalent to (and hence
has the same value as) a single forward contract at
this strike price and expiry.

r .(T t )
St pt Ct Xe

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1
8

PS10 - Florent Rouxelin 14/10/2017

 Lecture Summary: Put/Call Options
9
Call Option: Right, but not the obligation, to buy stock at strike price X at
maturity

Put Option: Right, but not the obligation, to sell stock at strike price X at
maturity

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 a)
10

Iron Butterfly using put and call options:

Short 1 put with strike price $50
Short 1 call with strike price $50
Long 1 put with strike price $45
Long 1 call with strike price $55

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 b)
11

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 b)
12

Iron Butterfly using call options and bonds:

Short 1 bond with face value $5
Long 1 call with strike price $45
Short 2 calls with strike price $50
Long 1 call with strike price $55

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 c)
13

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 c)
14

-> Option PREMIUM == Option PRICE

Iron Butterfly using put and call options:

Long 1 put with strike price $45 -> Price = $1.876
Short 1 put with strike price $50 -> Price = $3.730
Long 1 call with strike price $55-> Price = $4.013
Short 1 call with strike price $50 -> Price = $6.168

Cost of setting up the Iron Butterfly = Net cash flow received at time 0:

Premium Received=-$1.876+$3.730-$4.013+$6.168=$4

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 d)
15

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 d)
16
We believe that the price of the underlying security will be in
between $46 and $54. This way we have a positive profit:
PROFIT diagram:

Note that the diagram shifted up by the FUTURE value of the premium received at time 0. In other words, it
shifted up by $4*exp(r)=$4.2 (and not $4).
PS10 - Florent Rouxelin 14/10/2017
 Exercise 1 e)
17

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 e)
18

The same iron butterfly can be constructed by method a) or

b). By arbitrage argument, they must have the same price
We also know the net cash flow received at time 0: $4

By arbitrage argument using b):

Cost(Iron Butterfly) = -Call (X=$45) + 2* Call(X=$50) + $5*exp(-r)-Call(X=$55)
$4 = -$9.07-$4.013 + 2 x $6.168 + $5 exp(-r)

Solving for r, we get:

4.752
r ln( ) 0.05
5
PS10 - Florent Rouxelin 14/10/2017
 Exercise 1 f)
19

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 f)
20

PutCall parity: defines a relationship between

the price of a European call option and European put
option, both with the identical strike price and
maturity, namely that a portfolio of a long call option
and a short put option is equivalent to (and hence
has the same value as) a single forward contract at
this strike price and expiry.

r (T t )
St pt Ct Xe

PS10 - Florent Rouxelin 14/10/2017

 Exercise 1 f)
21

Using the put-call parity:

St Ct Xe r (T t ) pt

Using the call and the put with strike price X=$45:

St 9.070 45 e 0.05 1.876 $50

PS10 - Florent Rouxelin 14/10/2017

 Exercise 2
22

A stock has been trading in a narrow range around

$50 per share for months, and you believe it is going
to stay in that range for the next 3 months. The price
of a 3-month put option with a strike price of $50 is
$4. The risk-free (annually compounded) interest
rate is 10% per year.
a) What must be the price of a 3-month call option
on the stock with a strike price of $50 if it is at the
money?

PS10 - Florent Rouxelin 14/10/2017

 2 b)
23

b) What would be a simple options strategy using

ONLY a put and a call to exploit your belief about
stock price movement in the next 3 months? What is
the maximum profit you can make on this strategy?
How far can the stock price move, and in what
direction, to make you lose money?

PS10 - Florent Rouxelin 14/10/2017

 2 c)
24

c) How can you create a position involving a put, a call,

and a riskless bond that would mimic the payoff
structure of the stock at expiration?

d) What should be the arbitrage-free stock price if

there is no arbitrage opportunity, assuming the
premium for a 3-month call option with a strike price
of $50 is 6.18?

PS10 - Florent Rouxelin 14/10/2017