Problem Set 3

Group 9

1. Why do you think the most actively traded options tend to be the ones that are near the
money?

- Options that are near the money are usually those with the highest premium. A
high premium is clue for high potential gains

2. An investor buys a call at a price of $4.50 with an exercise price of $40. At what stock price
will the investor break even on the purchase of the call?

Break even price = strike price + option premium cost + commission and transaction
cost

= 40+4.50 = 44.50

3. You establish a straddle on Fincorp using September call and put options with a strike price of
$80. The call premium is $7.00 and the put premium is $8.50.

a. What is the most you can lose on this position? 7 + 8.5 = 15.5

b. What will be your profit or loss if Fincorp is selling for $88 in September?

( selling price- strike price - call premium) - put premium

(88-80-7)- 8.50

7.50

c. At what stock prices will you break even on the straddle?

Strike price + call premium + put premium

80 + 7 + 8.50

= 95.50

4. You are a portfolio manager who uses options positions to customize the risk profile of your
clients. In each case, what strategy is best given your client’s objective?

1. Performance to date: Up 16%. Client objective: Earn at least 15%.

Your scenario: Good chance of large stock price gains or large losses between now and
end of year.
 i. Long straddle.

ii. Long bullish spread.

iii. Short straddle.

2. Performance to date: Up 16%. Client objective: Earn at least 15%.

Your scenario: Good chance of large stock price losses between now and end of year.

i. Long put options.

ii. Short call options.

iii. Long call options.

5. An investor purchases a stock for $38 and a put for $0.50 with a strike price of $35. The
investor sells a call for $0.50 with a strike price of $40.

Call option = stock price - purchase price = 40 - 38 = $2

Put option = stock price - purchase price = 35 - 38 = -$3

a. What is the maximum profit and loss for this position?

Maximum profit = $2, maximum loss = -$3

b. Draw the profit and loss diagram for this strategy as a function of the stock price at

expiration.

6. The common stock of the P.U.T.T. Corporation has been trading in a narrow price range for
the past month, and you are convinced it is going to break far out of that range in the next
three months. You do not know whether it will go up or down, however. The current price of
the stock is $100 per share, the price of a three-month call option with an exercise price of
$100 is $10, and a put with the same expiration date and exercise price costs $7.

a. What would be a simple options strategy to exploit your conviction about the stock
price’s future movements?

The best simple option strategy to take would be a straddle position as it would be best to
purchase both a call and a put on the stock value. The total cost associated with this would be
17$.

b. How far would the price have to move in either direction for you to make a profit on
your initial investment?

For the cost to make a profit on the initial investment, it would need to move by 17$.

7. a. A butterfly spread is the purchase of one call at exercise price X1, the sale of two calls at
exercise price X2, and the purchase of one call at exercise price X3. X1 is less than X2, and X2 is
less than X3 by equal amounts, and all calls have the same expiration date. Graph the payoff

diagram to this strategy.

b. A vertical combination is the purchase of a call with exercise price X2 and a put with
exercise price X1, with X2 greater than X1. Graph the payoff to this strategy.

8. An executive compensation scheme might provide a manager a bonus of $1,000 for every
dollar by which the company’s stock price exceeds some cutoff level. In what way is this
arrangement equivalent to issuing the manager call options on the firm’s stock?

In the case of a call buyer, the market price of the stock will be greater than the exercise price
and the call holder will have a gain from the option they have. This is equivalent to issuing
the manager call options on the firm’s stock if the stock price goes above the cutoff value.
This is basically getting profit from a call option.
9. Consider the following portfolio. You write a put option with exercise price $90 and buy a put
with the same expiration date with exercise price $95.

a. Plot the value of the portfolio at the expiration date of the options.

b. Now, plot the profit of the portfolio. Hint: Which option must cost more? The greater
exercise price put option must cost more.

10. You buy a share of stock, write a one-year call option with X = $10, and buy a one-year put
option with X = $10. Your net outlay to establish the entire portfolio is $9.50. What is the payoff
of your portfolio? What must be the risk-free interest rate? The stock pays no dividends.

The payoff of the portfolio is 10$.

CHAPTER 16:

1. A call option with a strike price of $50 on a stock selling at $55 costs $6.50. What are the call
option’s intrinsic and time values?

Intrinsic value = 55 - 50 = $5

Time value = 6.50 - 5 = $1.50

2. A call option on Jupiter Motors stock with an exercise price of $75 and one-year expiration is
selling at $3. A put option on Jupiter stock with an exercise price of $75 and one-year expiration
is selling at $2.50. If the risk-free rate is 8% and Jupiter pays no dividends, what should the
stock price be?
= 3 - 2.50 + [75/(1+.08)]

= $69.94

3. Reconsider the determination of the hedge ratio in the two-state model (Section 16.2),
where we showed that one-third share of stock would hedge one option. What would be the
hedge ratio for each of the following exercise prices: (a) $120; (b) $110; (c) $100; (d) $90? What
do you conclude about the hedge ratio as the option becomes progressively more in the
money?

A. 0
B. .33
C. .67
D. 1

The option becomes progressively more in the money since the ratio goes on increasing
in extremes of 1.0.

4. Use the Black-Scholes formula to find the value of a call option on the following stock: Time
to expiration = 6 months

Standard deviation = 50% per year

Exercise price = $50

Stock price = $50 Interest rate = 3% Dividend = 0

7.35

5. Would you expect a $1 increase in a call option’s exercise price to lead to a decrease in the
option’s value of more or less than $1?

The call will decrease by less than $1

6. All else being equal, is a call option on a stock with a lot of firm specific risk worth more than
one on a stock with little firm-specific risk? The betas of the stocks are equal.

The option of the stock with a lot of firm specific risk is worth more because the stock with
higher firm-specific risk has higher volatility.

7. Should the rate of return of a call option on a long-term Treasury bond be more or less
sensitive to changes in interest rates than the rate of return of the underlying bond?

The rate of return of a call option on a long-term treasury bond will be more sensitive to
changes in the interest rate
8. If the time to expiration falls and the put price rises, then what has happened to the put
option’s implied volatility?

The put’s implied volatility increases due to the decreased expiration time and price

9. According to the Black-Scholes formula, what will be the hedge ratio (delta) of a put option
for a very small exercise price?

The value of the hedge ratio will be zero because as exercise price decreases, the exercise of
the put gets smaller.

10. Consider a six-month expiration European call option with exercise price $105. The
underlying stock sells for $100 a share and pays no dividends. The risk-free rate is 5%. What is
the implied volatility of the option if the option currently sells for $8? Use Spreadsheet 16.1 to
answer this question.

.2405 or 24.05%