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Econ 236: Financial Engineering

Professor Ai-ru (Meg) Cheng


Homework I

1. What is the lower bound for the price of a 6-month call option on a non-dividend-
paying stock when the stock price is $80, the strike price is $75, and the risk-free
interest rate is 10% per annum?
ANS:
The lower bound of this call option is

St − Ke−rτ = 80 − 75e−0.1(0.5)
= 8.86

2. What is a lower bound for the price of a 2-month European put option on a non-
dividend-paying stock when the stock price is $58, the strike price is $65, and the
risk-free rate is 5% per annum?
ANS:
The lower bound for this put option is

Ke−rτ − St = 65e−0.05(2/12) − 58
= 6.46

3. The price of a stock is $40. The price of a 1-year European put option on the
stock with a strike price of $30 is quoted as $7 and the price of a 1-year European
call option on the stock with a strike price of $50 is quoted as $5. Suppose that an
investor buys 100 shares, shorts 100 call options, and buy 100 put options. Draw a
diagram illustrating how the investor’s profit or loss varies with the stock price over
the next year.
ANS:
See the attached figure.

4. A trader owns gold as part of a long-term portfolio. The trader can buy gold for
$550 per ounce and sell it for $548 per ounce. The trader can borrow at 6% per year
and invest funds at 5.5% per year. For what range of 1-year forward prices of gold
does the trader have no arbitrage opportunities?
ANS:
548e0.055 < Ft < 550e0.06
578.98 < Ft < 584.01

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5. A stock is expected to pay a dividend $1 per share in 2 months and in 5 months.
The stock price is $50, and the risk-free rate is 8% per annum. An investor has just
taken a short position in a 6-month forward contract on the stock.
a) What is the forward price?
ANS:
Ft = ((S − D)er(2/12) − D)er(3/12) er(1/12)
Ft = 48.98.
b) Suppose 3 months later, the price of the stock is $48 and the risk-free rate of
interest is still 8% per annum. What is the forward price? What is the value of the
short position in the forward contract?
ANS:
Ft+3/12 = (S − D)er(3/12)
Ft+3/12 = 47.95.
ft+3/12 = (Ft − Ft+3/12 )e−r(3/12)
ft+3/12 = (49.98 − 47.95)e−0.02 = 1.9898.

6. It is July 16. A company has a portfolio of stocks worth $100 million. The β of the
portfolio is 1.2. The company would like to use the CME December futures contract
on the S&P 500 to change the β of the portfolio to 0.5 during the period July 16 to
November 16. The index futures price is 1000, and each contract is on $250 times the
index.
a) What position the company should take?
ANS:
N = −(1.2 − 0.5)(100, 000, 000)/(1, 000 ∗ 250) = −280, the company should take a
short position in 280 futures contracts.
b) Suppose the company decides to increase the β from 1.2 to 1.5. What positions in
futures contracts should it take? ANS:
N = −(1.2 − 1.5)(100, 000, 000)/(1, 000 ∗ 250) = 120, the company should take a long
position in futures contracts.

7. A fund manager has a portfolio worth 50 million with a β of 0.87. The manager
is concerned about the market performance over the next 2 months and plans to use
3-month futures contracts on the S&P 500 to hedge the risk. The current level of the
index is 1250, one contract is on 250 times the index., the risk-free rate is 6% per
annum, and the dividend yield on the index is 3%. The futures price is 1259. What
position should the manager take to hedge all exposure to the market over the next
2 months?
ANS:
N = −(0.87 − 0)(50.000, 000)/(1259 ∗ 250) = −138.2, the manager should take short
futures position.

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8. A European call option and put option on a stock both have a strike price of $20
and an expiration date in 3 months. Both sell for $3. The risk-free interest rate is
10% per annum, the current stock price is $19, and a $1 dividend is expected in 1
month. Identify the arbitrage opportunity open to a trader.
ANS:
One strategy for exploiting the arbitrage opportunity is to
At time t:

• short a call

• buy a put

• borrow St dollars to buy a share of stock

At the maturity
When ST < K:

• gain −max(ST − K, 0) = 0 from short call position

• gain K − ST from long put position

• sell the stock at gain ST

• gain $1 from dividend yield

• total: gain K = 20

• net profit: K + 1e0.1/6 − St e0.1/4 = $1.54

When ST > K:

• gain K − ST from short position

• gain 0 from put position

• gain ST from selling the share

• gain $1 from dividend

• total: K = 20

• net profit: $1.54.