Finance 100 Problem Set Options (Alternative Solutions)

Note: Where appropriate, the nal answer for each problem is given in bold italics for those not interested in the discussion of the solution. All payo diagrams include the initial cost of the security, however they do not take into account the time value of this cost by computing the future value. Each payo diagram is drawn with the future price of the security on the horizontal axis and the future payo to the position on the vertical axes. Strictly speaking, when computing the future payo to any position, we should calculate the future value of the money paid (or received) today when factoring this into the net position. This is not done here because the dollar impact is small and it adds little to the problem. I. Formulas This section contains the formulas you might need for this homework set: 1. Payo to a long position in a call option: P ayof f = max {ST K, 0} (1)

where ST is the price of the underlying security at expiration of the contract (time T ) and K is the strike price. 2. Payo to a short position in a call option: P ayof f = max {ST K, 0} = min {K ST , 0} 3. Payo to a long position in a put option: P ayof f = max {K ST , 0} 1 (3) (2)

4. Payo to a short position in a put option: P ayof f = max {K ST , 0} = min {ST K, 0} 5. Put-Call Parity (PCP): C = P + SedT KerT , (5) where C is the price of a call option, P is the price of an otherwise identical put option, S is the price of the underlying security, d is the dividend yield, T is the time to maturity (in years), K is the strike price and r is the risk-free rate. II. 1. 1.a The payo at maturity (net of the initial cost of the option) to the call buyer is given by max[0, ST K ] F V (C ), (6) where ST is the price of the underlying stock at maturity, K is the strike price and F V (C ) is the future value of the call premium (price), C. The net payo at maturity (net of the initial cost of the option) to the buyer of the put option at is, mathematically, max[0, K ST ] F V (P ), (7) where F V (P ) is the future value of the put premium, P. Graphically, these payos are depicted in Figures 1 and 2 below. 1.b The payo at maturity (net of the initial cost of the option) to the call seller is given by (max[0, ST K ] F V (C )) = min(0, K ST ) + F V (C ), (8) where ST is the price of the underlying stock at maturity, K is the strike price and F V (C ) is the future value of the call premium (price), C. The payo at maturity (net of the initial cost of the option) to the put buyer is given by (max[0, K ST ] F V (P )) = min(0, ST K ) + F V (P ), (9) where F V (P ) is the future value of the put premium, P. Graphically, these payos are depicted in Figures 3 and 4 below. 2 Problems (4)

Figure 1: Net Payo to a Long Call Po- Figure 2: Net Payo to a Long Put Position with $50 Strike Price
50 40 30 20 10 0 0 -10 Stock Price at Maturity 20 40 60 80 100
-10 Stock Price at Maturity Net Payoff at Maturity

sition with $50 Strike Price

50 40 30 20 10 0 0 20 40 60 80 100

1.c All of these graphs were done in Excel. The names of each position are provided upon request. You need not know them.

Net Payoff at Maturity

Figure 3: Net Payo to a Short Position Figure 4: Net Payo to a Short Position
in a Call Option with $50 Strike Price
10 0 Net Payoff at Maturity 0 -10 -20 -30 -40 -50 Stock Price at Maturity 20 40 60 80 100

in a Put Option with $50 Strike Price

10 0 Net Payoff at Maturity 0 -10 -20 -30 -40 -50 Stock Price at Maturity 20 40 60 80 100

Figure 1: (Protective Put): Buy one share and a put with strike price = $50
60 40 Net Payoff at Maturity 20 0 0 -20 -40 -60 Stock Price at Maturity 20 40 60 80 100 120

Buy Share Buy Put(50) Combined

Figure 2: (Bear Cylinder): Buy a put with strike = $50 and write (i.e. sell) a call with strike = $70
60 50 Net Payoff at Maturity 40 30 20 10 0 -10 0 -20 -30 -40 Stock Price at Maturity 20 40 60 80 100 120 Write Call(70) Combined Buy Put(50)

Figure 3: (Strangle I): Buy a call with strike = $70 and buy a put with strike = $50
60 50 Net Payoff at Maturity 40 30 20 10 0 0 -10 Stock Price at Maturity 20 40 60 80 100 120 Buy Call(70) Buy Put(50) Combined

Figure 4: (Strangle II): Buy a call with strike = $50 and buy a put with strike = $70
60 50 Net Payoff at Maturity 40 30 20 10 0 -10 -20 -30 Stock Price at Maturity 0 20 40 60 80 100 120 Buy Call(50) Buy Put(70) Combined

Figure 5: Short one share and buy a call with strike = $70
60 40 Net Payoff at Maturity 20 0 0 -20 -40 -60 Stock Price at Maturity 20 40 60 80 100 120 Short Share Buy Call(70) Combined

Figure 6: (Buttery Spread I): Buy call with strike = $50, buy call with strike = $70 and sell 2 calls with strike =$60
60 40 Net Payoff at Maturity 20 0 -20 -40 -60 -80 -100 Buy Call(70) Combined Sell 2xCall(60) Stock Price at Maturity 0 20 40 60 80 100 120 Buy Call(50)

Figure 7: (Buttery Spread II): Buy put with strike = $50, buy put with strike = $70 and sell 2 puts with strike =$60
60 40 Net Payoff at Maturity 20 0 -20 -40 -60 -80 -100 -120 Stock Price at Maturity Combined Sell 2xPut(60) 0 20 40 60 80 100 120

Buy Put(50) Buy Put(70)

1.d We will compute the price of a call implied by put-call parity (equation (5)), using the price of a put. We could have just as easily computed the price of a put implied by put-call parity, using the price of the call. It makes no dierence. To avoid a redundant calculation, the time to maturity in years for all options is 71/365 = 0.195. Table (1) below computes the relevant comparisons. The rst column is simply the dierent strike prices. The second column repeats the market value of each call from the table on the problem set. The third column reports the price implied by put-call parity. That is, the price of the call option using equation (5). The fourth column reports the dierence between the market price and the implied price. All units are in dollars, so the dollar sign is excluded. Clearly, there are a number of discrepancies between the market values and the put-call parity implied value. However, these discrepancies are likely due to market frictions such as: 1. The closing times for the options on the exchange might be dierent from those of the stock 9

Table 1: Call Prices Implied from Put-Call Parity vs. Actual Market Prices Market Call Implied PCP Price Strike (K) Price (P + S KerT ) Dierence 45 8.000 8.811 0.811 50 5.875 6.234 0.359 55 2.750 4.407 0.657 60 1.875 3.831 1.956 65 1.250 3.129 1.879 2. Put-Call parity is for European options. These are American options. 3. The dierence for the options at 50 are less than the transaction costs for the arbitrage. 4. Put-call parity relation above applies to non-dividend paying options only. (we assumed d=0) Thus, if 3Com was paying a dividend, we would have to account for this by using a non-zero value for d (which we would have to estimate). 1.e The price of portfolio iii from part 1.c is: Call(70) + P ut(50) = 0.0625 + 2.375 = 2.4375 The price of portfolio iv from part 1.c is: Call(50) + P ut(70) = 2.8125 + 20.75 = 23.5625 (11) (10)

Clearly, for the set of prices examined here, portfolio iv is more expensive. However, we must show that this is always the case, at any point in time and for any maturity. Intuitively, this result must be true for the following reason. Portfolio ivs assets (the 50 call and 70 put) are more likely to nish in-the-money than portfolio iiis (70 call and 50 put). A call is more likely to nish in-the-money, the lower the strike price, and a put is more likely to nish in-the-money the higher the strike price. So you are more likely to make money with portfolio iv than portfolio iii. Hence, the higher cost. We will now prove this result more formally. We want to show that the cost of portfolio iv, Call(50) + Put(70), is always greater than the cost of 10

portfolio iii, Call(70) + Put(50). Mathematically, we need to show: Call(50) + P ut(70) > Call(70) + P ut(50), which is equivalent to showing Call(50) + P ut(70) Call(70) P ut(50) > 0. (12)

Put-call parity allows us to write the value of the call options in terms of put options, the stock and cash: Call(50) = P ut(50) + Sedt 50erT Call(70) = P ut(70) + Sedt 70erT , (13) (14)

We now plug in the results from equations (13) and (14), into equation (12). This yields, [P ut(50)+Sedt 50erT ]+P ut(70)[P ut(70)+Sedt 70erT ]P ut(50) > 0 Simplication yields, 70erT 50erT > 0, which is true for all values of r and T . The result is proved. 1.f Since portfolios vi & vii have the same payo, they should have the same price. However, we see that the cost of portfolio vi is: Call(50) + Call(70) 2 Call(60) = 2 (if you want to think of this in terms of cash ows, just reverse the signs on each position). The cost of portfolio vii is: P ut(50) + P ut(70) 2 P ut(60) = 3.625 We can show that these two portfolios should be equal by using put-call parity in an identical manner as used above in part 1.e.

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1.g First, take a look at portfolio i. This portfolio is hedged in the sense that the downside risk associated with owning the share is hedged by buying the put. As the share price falls, we lose money on the share we own. However, we make money from the put option as the price falls and this osets the loss from owning the share. Now examine portfolio v. When we short-sell a share, we lose money as the price increases above the price at which we purchased the share. By buying the call, however, we make money as the share price increases above the strike. This osets losses in our short-sell position. 1.h If we believe that the volatility of the underlying asset price is going to be high, what we are saying is that we expect large swings in the stock price. That is, the stock price may move up or down, but when it moves, it will move a lot! In this scenario, we want to be holding portfolio iii since this pays o when the stock price moves far from its current position of $50.75. If we believe volatility will be falling, we are saying that we do not expect the stock price to move far from its current position. In this case, we want to be holding portfolio vi, since it pays o when the price is near its current position. 1.i Exactly the same logic applies. Greater volatility yields a desire to hold portfolio iv. Less volatility yields a desire to hold portfolio vii. 1.j Put-call parity begins with equation (5): C = P + S KerT , ignoring dividends. We can rearrange this equation to obtain C P = S KerT . Thinking in terms of cash ows, the left-hand side of the equation represents a cash inow of C (sell a call) and a cash outow of P (buy a put). The cash ows on the right-hand side represent a cash inow of S (buy the stock) and 12 (15)

the cash outow of KerT (lend cash). Plugging in values for S, K, r and T yields, C P = 50.75 60e0.0571/365 = 8.669 This is a cash outow, or cost, of $8.669, which diers from the market value, equal to 12.5 - 1.875 = 10.625. Again, rearranging the original put-call parity equation (5) yields, P C = KerT S (ignoring the dividend yield). The left hand side corresponds to cash inow of P (sell a put) and a cash outow of C (buy a call). The right hand side corresponds to a cash inow of KerT (borrowing cash) and a cash outow of S (buy the asset). Plugging in the numbers yields: P C = 65e0.0571/365 50.75 = 13.6209 This is a cash inow (or a negative cost). Note, this too diers from the market price of the portfolio: 16.75 - 1.25 = 15.50 (likely due to market frictions, such as those mentioned in part 1.d. 1.k See Excel Solutions 1.l See Excel Solutions 2. 2.a Our exposure (amount at risk) is 5 million SFR in 40 days. The American rms concern is that the exchange rate ($/SFR) will fall, meaning that each SFR can buy fewer $US. To hedge we will want to sell the 5 million SFR forward (i.e. in the future) by selling futures contracts on the SFR. Since our exposure is 5 million SFR and each futures contract is for 0.125 million SFR, we need 5 / 0.125 = 40 contracts to hedge all of our exposure.

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2.b Scenario 1 assumes that the spot exchange rate, 40 days hence, is 0.65 $/SFR. This implies that we can sell the 5 million SFRs we receive from the sale of goods for 65 cents per SFR, netting us 3.25 million $US. However, our cash balance from the short futures position is (0.7021 - 0.65) * 5 = 0.2605 million $US, osetting any loss from the transaction in the spot market. Our aggregate gain is 3.25 + 0.2605 = 3.5105 million $US. Scenario 2 assumes that the exchange rate will be 0.70 $/SFR in March. The company receives 0.70 * 5 = 3.5 million $US from sale of goods. Our futures position pays the company (0.7021 - 0.70) * 5 = 0.0105 million $US, for an aggregate position of 3.5 + 0.0105 = 3.5105 million $US. Scenario 3 assumes the exchange rate will be 0.75 $/SFR, implying that the company receives 0.75 * 5 = 3.75 million $US from the sale of goods (after exchanging the SFRs at the spot rate). The futures position suers a loss of (0.7021 - 0.75) * 5 = -0.2395 million $US. The aggregate position is: 3.75 - 0.2395 = 3.5105 million $US. Note, in all scenarios the aggregate position is unaected by the spot exchange rate in March. This is the perfect hedge. 2.c Since we want to sell Swiss Francs in the future, we want to buy put options, which gives us the option to sell the underlying asset in the future. Since each contract is for 0.0625 million SFRs, we need to sell 5/0.0625 = 80 contracts. Table (2) through (4) below looks at the eect of entering into 3 types of put contracts dierentiated by their strike price, when the spot exchange rate in March is 0.65, 0.70 and 0.75 $/SFR. Table 2: Scenario 1: Spot Exchange Rate in March = 0.65 $/SFR
Buy 80 contracts: Future Spot exchange rate Put Option Strike price Premium per SFR (Cost per unit) Total premium (cost per 80 contracts) Value when exercised (K > ST) Value from sale of 5m SFR Net payoff (disregard discounting) 0.65 0.695 0.0107 53,500 225,000 3,250,000 3,421,500 Exchange rate = 0.65 0.65 0.71 0.0196 98,000 300,000 3,250,000 3,452,000 0.65 0.74 0.0442 221,000 450,000 3,250,000 3,479,000

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Table 3: Scenario 2: Spot Exchange Rate in March = 0.70 $/SFR

Buy 80 contracts: Future Spot exchange rate Put Option Strike price Premium per SFR (Cost per unit) Total premium (cost per 80 contracts) Value when exercised (K > ST) Value from sale of 5m SFR Net payoff (disregard discounting) 0.7 0.695 0.0107 53,500 3,500,000 3,446,500 Exchange rate =0.7 0.7 0.71 0.0196 98,000 50,000 3,500,000 3,452,000 0.7 0.74 0.0442 221,000 200,000 3,500,000 3,479,000

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Table 4: Scenario 3: Spot Exchange Rate in March = 0.75 $/SFR

Buy 80 contracts: Future Spot exchange rate Put Option Strike price Premium per SFR (Cost per unit) Total premium (cost per 80 contracts) Value when exercised (K > ST) Value from sale of 5m SFR Net payoff (disregard discounting) 0.75 0.695 0.0107 53,500 3,750,000 3,696,500 Exchange rate = 0.75 0.75 0.71 0.0196 98,000 3,750,000 3,652,000 0.75 0.74 0.0442 221,000 3,750,000 3,529,000

The conclusions to be made from the tables are as follows. Options do not oer a perfect hedge in the sense that we do not know for certain what our future payo will be. They do oer a oor, or minimum amount, along with unlimited upside. Of course, the price of maintaining this upside is the cost of the option. Their is also a tradeo between the higher strike price (more likely to nish in-the-money and the higher premium). The hedge transaction itself has a zero NPV. 2.d The futures hedge locks in an exchange rate. We know for certain what our future payo will be, regardless of what happens to the underlying spot exchange rate. The option hedge is more uncertain. While we are guaranteed a minimum payo, we do need a bit of upside movement in the exchange rate to recoup the initial cost of the option contracts (there is no cost to entering futures contracts, beyond transaction costs). Beyond recovering the initial cost of the option contracts, the upside gains are unlimited for the option hedge. Assuming there is no private information, there is little reason to hedge using the options when the futures contracts accomplish this goal at a cheaper price and with no uncertainty. 2.e The CEO is incorrect. Assuming the company has another buyer oering an amount in $US that the rm would otherwise get from the sale to the Swiss rm at 0.695 $/SFR, the rm should exit the sale and take the cash from their futures position. Agreeing to the sale at that point would force the rm to take a loss on the sale of goods. Something they need not do under the exit clause. 16

2.f The company breaks even at an exchange rate of 0.695 $/SFR. That is, they are indierent between selling at 0.695 and not selling at all. So, the exit clause acts in the exact same manner as the put option. Therefore, it should have the same value as the put, or $53,500 (see above). This is an example of a real option. 3. The parameters of the problem are: 1. Price of call option (C) = $3.10 2. Price of put option (P) = $0.40 3. Strike (K) = $45 4. Current Stock Price (S) = $46.60 5. Risk-free interest rate (r) = 5% 6. Time to expiration, in years (T) = 1/12 = 0.0833 Put-call parity is violated since C = P + S KerT = 0.4 + 46.6 45 e0.050.0833 = 2.19, which is less than the market price of $3.10. We can use the put-call parity violation to tell us what arbitrage strategy to undertake. The intuition is as follows. We know the market price of the call is too high so that C > P + S KerT . Now lets rearrange the equation so that we get an expression that is greater than zero. By doing this, and interpreting the dollar amounts as cash ows, we are saying that the cash ows today will be greater than zero, implying an arbitrage since we know the cash ows in the future will be the same. A little algebra reveals C P S + KerT > 0. 17

Table 5: Arbitrage Table At Maturity Position Today St < K St > K Sell Call 3.10 0 (ST 45) Buy Put -0.40 45 ST 0 Buy Stock -46.60 ST ST Borrow Cash 44.81 -45 -45 Net Cash Flows 0.91 0 0 Think of this equation in terms of the cash ows at time 0 (i.e. today). To receive a positive cash ow of C today, we must sell the call option. But, this makes sense since the call option price in the market is too high. The negative cash ows of -P and -S correspond to buying the put and buying the stock. The positive cash ow of KerT reects borrowed cash. The arbitrage table is presented in (5).

These solutions are produced by Michael R. Roberts. Thanks go to Jen Rother for her excellent assistance, and to an anonymous TA. Any remaining errors are mine.

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