1a.

Answer
The current strike price of $80 will be split into two call options using 2-for-1 stock split rule.
Hence, strike price for each call option will be $80/2 = $40.
1b. Answer
i. For a 20% stock Dividend
No of Shares Strike Maturity Stock
Price Dividend
200 80 6 Months 20%
Option Contact Exercise Price
240 66.67
Hence, the option contract will become one to buy 200 x 1.2 = 240 shares with an
exercise price 80/1.20 = 66.67.
ii. For a 20% cash dividend
There will be no effect for 20% cash dividend, because the terms of an options contract
are not normally adjusted for cash dividends.
2a. Answer
i. If stock price volatility increases
This will result in an increase in value of a call option, based on rule of “The greater
the expected volatility, the higher the option value”.
ii. If the time expiration increases
This will also result in an increase in value of call option, based on the rule of “The
longer the time until expiration, the higher the option price”.
2b. Answer
i. For an European Call Option
European call option gives a right to the option holder to purchase one share stock
for a certain price. The option itself cannot be worth more than the stock.
The upper bound for European Call Option is: C ≤ S0, C ≤ S0
In case this condition does not hold, we can make profit by selling an option and
buying a stock.
ii. For an European Put Option
European put option gives the holder the right to sell one share of stock for the strike
price. The put option cannot be worth more than the strike price.
The upper bound for European Put Option is: P ≤ K, P ≤ K
However, since European option can be exercised at maturity only, the European
put option cannot be worth more than the present value of the strike price.
3a. Answer
Portfolio A: one European call option plus an amount of cash equal to 𝑋𝑒 −rT .
Portfolio B: one share of underlying stock
After 𝑇 years portfolio A will yield an amount of cash equal to 𝑋.
If, after 𝑇 years, the stock price 𝑆𝑇 is above 𝑋, the call option in portfolio A will be exercised,
the share sold and the portfolio will be worth 𝑆𝑇. Otherwise, after 𝑇 years, 𝑆𝑇 ≤ 𝑋, the option
is not exercised and the portfolio will be worth 𝑋.
Hence after T years portfolio A is worth max(𝑆𝑇 , 𝑋) ≥ 𝑆𝑇, and since portfolio B is always
worth 𝑆𝑇 after 𝑇 years, the initial value of portfolio A must be no less that the initial value of
portfolio B, which is just 𝑆.
3b. Answer
Portfolio C: one European put option plus one share of underlying stock.
Portfolio D: an amount of cash equal to 𝑋𝑒 −rT .
After 𝑇 years portfolio D will be worth 𝑋.
If, after 𝑇 years, 𝑆𝑇 < 𝑋, then the put option in portfolio C will be exercised; the share is sold
for 𝑋 and the portfolio will be worth 𝑋. Otherwise, if after 𝑇 years, 𝑆𝑇 ≥ 𝑋, the option is not
exercised and the portfolio will be worth 𝑆𝑇.
So after 𝑇 years portfolio C is worth 𝑚𝑎𝑥(𝑆𝑇 , 𝑋) and the initial value of portfolio C must be
no less that the initial value of portfolio D which is just 𝑋𝑒 −rT .

3c. Answer
Portfolio A: one European call option plus an amount of cash equal to 𝑋𝑒 −rT .
Portfolio C: one European put option plus one share.
After T years they are both worth 𝑚𝑎𝑥(𝑆𝑇 , 𝑋) where ST is the stock price after T years.
These two portfolios must have identical initial values, hence the put-call parity equation is:
𝑐 + 𝑋𝑒 −rT = 𝑝 + 𝑆.

4a. Answer
A long straddle position is entered into simply by buying a call option and a put option with
the same strike price and the same expiration month. The maximum profit potential on a long
straddle is unlimited. The maximum risk for a long straddle will only be realized if the position
is held until option expiration and the underlying security closes exactly at the strike price for
the options.
4b. Answer
Breakeven price for call option will be = Strike Price + Cost of the call option = $20 + $5 =
$25, and Breakeven price for put option will be = Strike Price - Cost of the put option = $20 -
$3 = $22
4c. Answer
Profit and loss diagram for a long straddle looks like this:

Long Straddle
40
PROFIT OR LOSS

20

0
1 2 3
-20

-40
STOCK PRICE AT EXPIRATION
5a. Answer
The delta of a European futures call option is usually defined as the rate of change of the
option price with respect to the futures price (not the spot price).
In this case:
- - - - - - - - - - - - - - - - - - - - - - - - - - - - 𝑆𝑂 = 80 , 𝐾 = 85 , 𝑟𝑓 = 0.1 , 𝜎 = 0.1, 𝑇 = 0.5

Hence,
80 0.12
ln( )+(0.1 ( ) 𝑋 0.5
85 2
- - - - - - - - - - - - - - - - - - - - - - - - - - - - 𝑑1 = 0.1√0.5

- - - - - - - - - - - - - - - - - - - - - - - - - - - - 𝒅𝟏 = -0.8538
5b. Answer
The Value of risk-free portfolio at the end of six months is
- - - - - - - - - - - - - - - - - - - - - - - - - - - - 𝑒 −𝑟𝑡 𝑁(𝑑1 )
- - - - - - - - - - - - - - - - - - - - - - - - - - - - 𝑁(𝑑1 ) = 0.3023
- - - - - - - - - - - - - - - - - - - - - - - - - - - - 𝑒 −(0.1)(0.5)x 𝑁(𝑑1 )
- - - - - - - - - - - - - - - - - - - - - - - - - - - - = 0.2875
5c. Answer
The Value of risk-free portfolio today is
- - - - - - - - - - - - - - - - - - - - - - - - - - - - 𝑒 −𝑟𝑡 𝑁(𝑑1 )
- - - - - - - - - - - - - - - - - - - - - - - - - - - - 𝑁(𝑑1 ) = 0.3023
- - - - - - - - - - - - - - - - - - - - - - - - - - - - 𝑒 −(0.1)(0.01)x 𝑁(𝑑1 )
- - - - - - - - - - - - - - - - - - - - - - - - - - - - = 0.30199

5d. Answer
The value of call option today is
- - - - - - - - - - - - - - - - - - - - - - - - - - - - $80 x 𝑒 −𝑟𝑡 𝑁(𝑑1 )
- - - - - - - - - - - - - - - - - - - - - - - - - - - - = $80 x 0.30199 = $24.16
6a. Answer
Stock Price = $80
Strike Price = $85
Rf = 0.1
Volatility = 0.1
There are two six months period hence T= 0.5 for each period, The binomial tree will be as
following:
$88.88

$88

$80 $88.88

$72

$71.28

6b. Answer:
Yes, this could be exercised early at $88 in first period of 6 months, because the only difference
between evaluating American and European option is that when pulling back for an American
option, we need to always compare the pulled back value and the exercise value. If the pulled
back value is greater than the exercise value, continue moving backwards along the tree using
this value. And, if the pulled back value is less than the exercise value, then exercise is optimal
and we need to use this value to move backwards along the tree.

7 Answer:
Information
Stock Price now (P) 80
Exercise Price of Option (EX) 75
Number of periods to Exercise in years (t) 0.25
Compounded Risk-Free Interest Rate (rf) 8.00%
Standard Deviation (annualized  20.00%

Equation Solution
Present Value of Exercise Price (PV(EX)) 73.5149
*t^.5 0.1000
d1 0.8954
d2 0.7954
Delta N(d1) Normal Cumulative Density Function 0.8147
Bank Loan N(d2)*PV(EX) 57.8419

Value of Call 7.3348

8 Answer:
Information
Stock Price now (P) 80
Exercise Price of Option (EX) 75
Number of periods to Exercise in years (t) 0.25
Compounded Risk-Free Interest Rate (rf) 8.00%
Standard Deviation (annualized  20.00%

Equation Solution
Present Value of Exercise Price (PV(EX)) 73.5149
*t^.5 0.1000
d1 0.8954
d2 0.7954
Delta N(d1) Normal Cumulative Density Function 0.8147
Bank Loan N(d2)*PV(EX) 57.8419

Value of Put 0.8497