Ec1723, Spring 2025: Problem Set 7 – Solutions

Problem 1
Suppose today is April 15, 2025. The closing price of a put option on MAGIC Inc. with
exercise (strike) price 182 and expiration date (end of) May 5, 20251 is 6. The closing price
of a share of MAGIC stock is 180.

(a) Using put-call parity, calculate the implied price of a call option with the same strike
and expiration date as the put above. Assume that annualized interest rates are 1%.
d
Note that the relevant interest rate is given by (1 + R) 365 , where d is the number of
natural days to expiration.
Put-call parity says
d
Call − Put = Underlying − Strike/(1 + R) 365
15+5
Call = 6 + 180 − 182/1.01 365

= 4.099204 ≈ 4.1

where the second line uses d = 15 + 5 because there are 15 remaining days in April,
and 5 in May prior to expiration.

(b) Suppose you are told that the actual price of the call above is 5. Is this the same as
you calculated in (a)? If not, how would you take advantage of the apparent arbitrage
opportunity?
The implied call price is below the true price. To be able to exploit arbitrage opportu-
nities, we should, as usual, for a product and its replication, buy the cheaper (buy low),
and sell the more expensive (high). In this case, we should sell the call and borrow just
enough (given a 1% interest rate) to owe 182 when the options expire. We should use
the proceeds to buy a put and a share of stock. Assuming away transactions costs, we
get 5 − 4.1 = 0.9 today. If the call is in the money at expiration, we will owe S − 182
to the buyer of the call and 182 to the lender. We can cover our positions by selling
our share of the stock to get S. If the call is out of the money at expiration, we will
owe nothing to the buyer of the call and 182 to the lender. We will get 182 − S from
our put and S from selling our share of stock, so we will be able to cover our positions
in this case too.
Note (additional, not required): in reality, we have to take into account the transaction
costs. Trading options is not cheap, and typically, if traded at a central clearing house
(like the Chicago Board of Options Exchange), one needs to post margins to be able
to trade options.
1
So, expiration date is 20 days after today

1
 (c) Now you are told that the interest rate of 1% is no longer valid. What should be the
prevailing interest rate that makes the implied call price equal the quoted call price?
We need to solve for R such that
20
5 = 6 + 180 − 182/(1 + R) 365
365
R = (182/181) 20 − 1
≈ 10.57%

Problem 2
The price of stock XYZ today is 100. Over the next year it will either rise to SU = 150, or
fall to SD = 70. Suppose risk-free interest rates are zero.

(a) You are asked to write a put option on stock XYZ that has a strike K of 100 dollars.
Make a two-period binomial tree diagram to show the price of the stock in both states,
and the price of the option in both states next years.
Stock price will either be SU = 150 in the up state or SD = 70 in the down state.
Thus, put value will be max(K − SU , 0) = 0 in the up state and max(K − SD , 0) = 30
in the down state.

(b) Solve for the portfolio holdings of cash and stocks today that reproduces the cash flows
of the put option next year in each state2 . Also, solve for the price of the option.
From Lecture 21, we can replicate the put option by holding H units of the stock and
bills with face value B, where H and B satisfy:

150H + B = 0
70H + B = 30
3 225
⇒ H = − = −0.375, B = = 56.25
8 4
The price of the put must equal the price of the replicating portfolio. Therefore, we
have
3
P0 = − (100) + 56.25 = 18.75
8

2
Note that in this problem (and in the problem set in general) we can buy or sell fractional shares of the
underlying. Of course, holdings can be negative (short/sell)

2
 (c) If the writers of options perfectly hedge the cashflow payments in time 1 by trading
in stocks and bonds, then what do put writers do in response to a surge in demand to
buy puts from their customers, i.e. what trading strategy do they follow?
A portfolio that writes a put option and sells 3/8 of the underlying stock would be
hedged. Thus, put options writers would hedge their put positions by shorting the
underlying stock. If there’s a surge in demand to buy puts, options writers would need
to short a large amount of the underlying stock in order to maintain their hedge.

(d) What could the put writers hedging strategy do to stock prices ? Explain.
Shorting the underlying stock would lower the price of the stock even further. This
could create even more demand for put options.

Problem 3
For this problem, please refer to the figure for Question 2 below. In the diagram, the (x, y)
coordinates of the points at which the payoffs turn are listed in parentheses. For example
(0,100) shows that when ST , the stock price at time T , is 0, then the portfolio provides a
payoff of 100 dollars at time T .

Create a position that combines options, stocks, and risk-free zero coupon bonds (time
0) that provides the payoff depicted in the diagram at date T as a function of the stock price
at date T . Explain the strategy, i.e. how many stocks and bonds are you buying, what is
the strike price of the options, are you buying or writing, and how many. Assume the net
net risk-free rate is 0.

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 Finally, note that more than one answer is possible. As the put-call parity shows, there
are different ways of combining options, stocks, and bonds, to generate the same payoff.
First, let’s derive the expression for the payoff as a function of the underlying price ST
from its graphical representation. Using basic analytic geometry, it is clear from the graph
that the payoff function is:


 80 if ST < 150

S − 70 if S ∈ [150, 250]
T T
Payoff(ST ) =


 430 − ST if ST ∈ (250, 350]

80 if ST > 350

The objective now is to find combinations of calls, puts, stocks and risk-free asset that
replicate this payoff structure. The two tables that follow provide a fully worked solu-
tion—first with calls, then with puts—to match the four-segment payoff drawn in the figure.
After the tables, we explain how those rows were chosen, using a simple “slope-and-kink”
guideline.

• Calls and bills:

Position ST < 150 150 ≤ ST ≤ 250 250 < ST ≤ 350 ST > 350
Buy Call, X1 = 150 0 ST − 150 ST − 150
ST − 150

Write 2 Calls, X3 = 250 0 0 2 250 − ST 2 250 − ST
Buy Call, X2 = 350 0 0 0 ST − 350
Buy Bills, FV = 80 80 80 80 80
Total 80 ST − 70 430 − ST 80

• Puts and bills:

Position ST < 150 150 ≤ ST ≤ 250 250 < ST ≤ 350 ST > 350
Buy Put, X2 = 350 350 − ST
350 − ST
350 − ST 0
Write 2 Puts, X3 = 250 2 ST − 250 2 ST − 250 0 0
Buy Put, X1 = 150 150 − ST 0 0 0
Buy Bills, FV = 80 80 80 80 80
Total 80 ST − 70 430 − ST 80

These are known as butterfly spreads. Note: these two tables are not necessarily the only
way to reproduce the target payoff function. Different mixes of calls and puts, or including
the underlying stock might deliver the same payoff structure. Argualbly, we provided the
simplest combinations.

Step-By-Step Explanation: How to Find Replicating Portfolios from Target Pay-

off Function
Interpreting a finished replication table is usually straightforward—you can read off each
row and immediately see how it adds to the final payoff. What is sometimes tricky is the

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forward task: starting from a blank page and finding a portfolio whose payoff matches a
given target. The next paragraphs give one practical shortcut for that purpose. It is not the
only road to a solution—other payoffs may require a share of the underlying, different mixes
of calls and puts, or bonds that must be discounted when the risk-free rate is non-zero—but
an analogous logic of matching slopes and levels would apply so the method is a useful
starting point in other replication exercises involvings calls and options.
Conceptual roadmap.
A piece-wise–linear payoff can be built entirely from constant–slope blocks (options) plus
a vertical lift (a bill). The guiding rules are:

• Slope. A long call contributes slope +1 to the right of its strike; a short call contributes
slope −1. (Long/short puts do the same to the left of their strike.)
• Kink. Every break in the graph’s slope must coincide with an option strike.
• Direction (just for convenience). If you use only calls (and bills), walk left → right:
each higher-strike call affects regions that have not yet been fixed. A long call begins
to pay only once the stock price crosses its strike, and its payoff thereafter is linear.
Therefore, if you assemble the position with calls and proceed from left to right,

– every new (higher-strike) call you add influences only the regions to its right,
i.e. regions you have not handled yet;
– the payoff you already matched on the left stays intact, so you never have to “go
back” and re-tune earlier segments.

In other words, the construction becomes one-directional and sequential: at each kink
you look only at the next region, decide whether you need slope +1 (buy a call) or
slope −1 (short two calls, etc.), fix that region, then move on. If you prefer puts,
you do the mirror image—start at the far right and walk right → left for the same
“no-retro-fitting” convenience.

Below we illustrate the call construction; the put construction is obtained by reversing
long ↔ short and right ↔ left.
Step-by-step construction with calls (left → right).

1. Match the flat floor. The graph never drops below $80, so buy a zero-coupon bond
paying $80 at T . (All four regions now start at 80.)
2. Insert slope +1 on [150, 250]. Region 2 rises $1 per $1 increase in ST . Add +1 long
call with strike K1 = 150.
3. Flip the slope to −1 on (250, 350]. Region 3 must fall, so remove 2 units of +1 slope:
write 2 calls at K2 = 250.
4. Flatten the payoff beyond $350. Region 4 is horizontal; add back +1 of slope by buying
one call at K3 = 350.

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 5. Confirm each region.
• ST < 150: no calls in-the-money ⇒ 80.
• 150 ≤ ST ≤ 250: 80 + (ST − 150) = ST − 70.
• 250 < ST ≤ 350: 80 + (ST − 150) − 2(ST − 250) = 430 − ST .
• ST > 350: all call payoffs net to zero ⇒ 80.

Replication table (calls + bill).

Position ST < 150 150 ≤ ST ≤ 250 250 < ST ≤ 350 ST > 350
Buy Call (K1 = 150) 0 ST − 150 ST − 150 ST − 150
Write 2 Calls (K2 = 250) 0 0 2(250 − ST ) 2(250 − ST )
Buy Call (K3 = 350) 0 0 0 ST − 350
Buy Bill (FV = 80) 80 80 80 80
Total 80 ST − 70 430 − ST 80

Put-based replication. Walking from the right edge and using puts instead:

• Buy 1 put at K3 = 350 (adds slope +1 left of 350).

• Write 2 puts at K2 = 250 (removes 2 units of slope).
• Buy 1 put at K1 = 150 (restores flatness left of 150).
• Add the same $80 bill.

Position ST < 150 150 ≤ ST ≤ 250 250 < ST ≤ 350 ST > 350
Buy Put (K3 = 350) 350 − ST 350 − ST 350 − ST 0
Write 2 Puts (K2 = 250) 2(ST − 250) 2(ST − 250) 0 0
Buy Put (K1 = 150) 150 − ST 0 0 0
Buy Bill (FV = 80) 80 80 80 80
Total 80 ST − 70 430 − ST 80

Either portfolio reproduces the target four-region payoff. The call version is a standard
butterfly, and the put version its mirror image under put–call parity.

Problem 4
(From the 2013 final exam.) A stock follows a binomial process over two periods. The
time-0 price is $200, and the time-1 prices are either $180 or $240. If the time-1 price is
$180, the time-2 price can be either $162 or $216. If the time-1 price is $240, the time-2
price is either $216 or $288. The stock pays no dividends. The riskless interest rate is 2%
per period.

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(a) Draw the binomial tree. Show that the volatility of the stock return is the same at
time 0 and at each of the two possible states in time 1. For this you may assume that
the probabilities of up and down moves are constant over time.
Given that the probabilities of up and down moves are constant, it suffices to show
that the set of possible returns is the same at every node. At the first node, the price
goes down by 10% or up by 20%. The same is true at both of the subsequent nodes,
which is exactly what we needed.

(b) Calculate the value of a call option, expiring at time 2 with exercise price $200, at time
0 and at each of the two possible states in time 1.
First, we need to know what the payoffs will be in each state. In state uu, the call is
worth 288 − 200 = 88. In states du, it is worth 216 − 200 = 16. In state dd, it is worth
nothing. Now we build a replication portfolio. Suppose the state at t = 1 is u. To get
88 if the stock goes up and 16 if it goes down, we need

88 = 288su + 1.02bu
16 = 216su + 1.02bu
200
⇒ su = 1 and bu = −
1.02

This will cost

200
240 − ≈ 43.9.
1.02
This is the value of the call in state u. Now suppose the state at t = 1 is d. To get 16
if the stock goes up and 0 if it goes down, we need:

16 = 216sd + 1.02bd
0 = 162sd + 1.02bd
8 48
⇒ sd = and bd = − .
27 1.02

This will cost:

8 48
180 − ≈ 6.27.
27 1.02
This is the value of the call in state d. Back at t = 0, we need:

200
240 − = 240s + 1.02b
1.02
8 48
180 − = 180s + 1.02b
27 1.02
⇒ s ≈ 0.627 and b ≈ −104.47

This will cost about 23, which is the initial value of the call.

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(c) Calculate the hedge ratio for the call option at time 0 and at each of the two possible
states in time 1.
The hedge ratio in state u is
88 − 16
= 1.
288 − 216
The hedge ratio in state d is
16 − 0 8
= ≈ 0.296.
216 − 162 27
The initial hedge ratio is
   
200 8 48 
240 − − 180 − (240 − 180) ≈ 0.627.
1.02 27 1.02

Notice that these are the values of su , sd , and s respectively (not by coincidence).

(d) Use your analysis to show that a portfolio insurance strategy (replicating a stock plus a
put option) sells stocks as stock prices fall. Your answer to this part can be qualitative
rather than quantitative.
The call we have priced gives payoffs just like a portfolio insurance strategy. In the
example above, we saw that the number of shares held per option is initially about
0.627. If stock prices fall, then the number of shares held per option is only about
0.296, so most of the shares must be sold.