Financial Markets HEC Paris – Fall 2020

Problem Set 4: Options

Problem 1
An American investor buys one call option on the euro at an exercise price of $1.1 per euro. The
option premium is $0.01 per euro.
a. For what range of exchange rates will the investor exercise the call option at expiration?
b. For what range of exchange rates will the investor realize a net profit, taking the original cost
into account and using a risk-free interest rate of 0%?
c. If the investor had purchased a put with the same exercise price and premium instead of a call,
how would your answers to the two questions above change?

Problem 2
You think LVMH’s stock price is going to appreciate substantially in the next six months. LVMH’s
current price is equal to e100, and a European call option on LVMH with a six-month maturity and
an exercise price e100 has a price of e10. You have e10,000 to invest, and you can:
(i) Invest e10,000 in the stock.
(ii) Invest e10,000 in 1,000 call options (one option gives you the right to buy one share of Peugeot
in six months).
(iii) Buy 100 options and invest the remaining e9,000 in a risk-free money market fund paying 4%
over six months (4% is the effective semi-annual rate, that is, the effective annual rate is 8.16%).
What is your holding period return if LVMH’s stock price six months from now is (a) e80, (b) e100,
(c) e110, (d) e120?

Problem 3
The following financial derivatives have the same underlying asset and the same maturity date:
• A European Call option with exercise price 80
• A European Call option with exercise price 90
• A forward contract with delivery price 70

a. Draw the payoff diagram of the forward contract (that is, plot the payoff at maturity of a long
position in the forward as a function of the spot price of the underlying asset at maturity).
b. Draw the payoff diagram of a portfolio composed of one long position in the forward and one
short position in the call option with exercise price 90.
c. Find a portfolio that contains some units of the three derivatives above and with a payoff at
maturity as follows:

slope = +2

slope = −1

80 90
−10

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 d. The underlying asset trades at 80 today. An investor decides to invest massively in the portfolio
of question c). Which is most likely: (i) the investor thinks that the market under-estimates the
volatility of the underlying asset; or (ii) the investor thinks that the market over-estimates the
volatility of the underlying asset? Explain.

Problem 4
Suppose that you bought one forward contract (forward price F0 = 100) and two European puts
(strike K = 100) and sold one European call (strike K = 120) on the same underlying asset and the
same maturity.

a. Draw carefully the payoff diagram of your portfolio at date T , i.e., your cash flows CFT as a
function of the underlying asset spot price ST .

b. Which one(s) of the following four explanations is most likely to justify the purchase of this
portfolio:

(i) You think that the market underestimates the true value of the underlying asset.
(ii) You think that the market overestimates the true value of the underlying asset.
(iii) You think that the market underestimates the price volatility of the underlying asset.
(iv) You think that the market overestimates the price volatility of the underlying asset.

c. Which one(s) of the following three reasons would best explain why you decided to sell the call
with K = 120:

(i) You wanted to reduce the overall initial cost of the portfolio.
(ii) You wanted to benefit from a drop in the price of the underlying asset.
(iii) You wanted to limit your downward exposure in case of an increase in the price volatility
of the underlying asset.

Problem 5

You have the following information on two European options that have the same underlying asset:

Put option: maturity 2 years; strike price 100; put price 8

Call option: maturity 2 years; strike price 100; call price 5

Furthermore, you know that the underlying asset currently trades at a price 90, that the term structure
of interest rates is flat, and that the annual risk-free rate is 5%.

a. Assume in this question only that the underlying asset does not pay any dividend between now
and t=2 years. Is there an arbitrage opportunity? If yes, show the arbitrage strategy in a cash
flow table.

Assume from now on that the underlying asset will pay a dividend of 15 at t=1 year.
K D
b. Show that the put-call parity now writes C0 + (1+r 2 = P0 + S0 − 1+r . [Hint: find a portfolio
f) f
containing a long position in the call and in the risk-free asset and another portfolio containing
a long position in the put and in the stock and a short position in the risk-free asset, that have
the same cash flows and apply the law of one price.]

c. Is there an arbitrage opportunity? If yes, show the arbitrage strategy in a cash flow table.

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Problem 6
Stock XYZ is selling for e100 today (t=0). Two states of the economy are possible in one year (t=1).
In the good state of the economy, the stock will sell for e120. In the bad state of the economy, it will
sell for e90. XYZ will not pay any dividend in the years to come. The risk-free interest rate is 3%.
We consider the following European options:

Underlying asset Expiry Strike price Price at t=0

Call option 1 Stock XYZ T=1 e100
Call option 2 Stock XYZ T=1 e110 e4.21
Put option 1 Stock XYZ T=1

Put 1 will pay e20 at date 1 in the bad state of the economy.

a. How much will Put 1 pay at date 1 in the good state of the economy?

b. What is the price of Put 1 today?

c. What is the price of Call 1 today?

d. What would be the price of Call 2 today if Call 2 was American instead of European?

Assume in questions e) and f) only that you can only trade stock XYZ and Put option 1 (you cannot
trade the call options). We consider security ABC, which will pay e12 in the good state of the economy
and e19 in the bad state of the economy at date 1.

e. Show how you can replicate the payoffs of this security (using only Put 1 and stock XYZ and
assuming that you can buy or sell fractions of any security.) What is the no-arbitrage price of
security ABC?

f. Assume that security ABC sells for e16 today. Find an arbitrage strategy and provide a table
that contains the detail of your trades and transactions at dates 0 and 1.

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 Problem Set 4: Options

Solutions

Problem 1

a. Exercise the call at maturity if USD/EUR > 1.1

b. Profit will be positive when USD/EUR − 1.1 > 0.01, i.e., when USD/EUR > 1.11

c. Exercise put if USD/EUR < 1.1. Profit will be positive when 1.10 − USD/EUR > 0.01, i.e.,
when USD/EUR < 1.09.

Problem 2

Stock price = 80 100 110 120

CF in six months
(i) All stocks (100 shares) 8,000 10,000 11,000 12,000
(ii) All options (1000 options) 0 0 10,000 20,000
(iii) Bills + Options 9,360 9,360 10,360 11,360

Rate of return
(i) All stocks (100 shares) −20% 0% 10% 20%
(ii) All options (1000 options) −100% −100% 0% 100%
(iii) Bills + Options −6.4% −6.4% 3.6% 13.6%

Problem 3

a.

70

−70

b.

20

70 90

−70

c. Sell 1 forward contract, buy 1 call option with K = 80, and buy 2 call options with K = 90.

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 d. That the market under-estimates volatility. Once we take into account the cash-flows at date 0,
the strategy makes money if the price moves a lot and loses some if the price does not move too
much.

Problem 4

a.

100

20

100 120

b. (ii) and/or (iii)

The strategy pays off if the price moves far away from 100, therefore (iii).

The payoff is the larger when the price approaches 0, therefore (ii).

c. (i)

Selling the call generates a positive payoff at t=0, therefore (i).

Problem 5

a. There is no arbitrage opportunity if the put-call parity holds:

K
C0 + = P0 + S 0
(1 + rf )T
K 100
Since instead C0 + (1+r T = 5 + 1.052 = 95.70 and P0 + S0 = 8 + 90 = 98, the call is underpriced
f)
relative to put. The arbitrage strategy is the following:

t=0 t=T t=T

if ST < K if ST > K
Buy the call −5 0 ST − 100
100
Invest 1.052 = 90.70 at the risk-free rate −90.70 100 100
Sell the put 8 ST − 100 0
Short-sell underlying asset 90 −ST −ST
Total payoff 2.30 0 0

b. We follow the same logic leading to the put-call parity without dividends that we studied in
class. The first portfolio is:

t=1 t=2
if ST < K if ST > K
Long position in the call 0 0 ST − K
K
Invest (1+rf)
2 at the risk-free rate at t=0 for 2 years 0 K K
Total payoff 0 K ST

The second portfolio is:

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 t=1 t=2
if ST < K if ST > K
Long position in the put 0 K − ST 0
Long position in the stock D ST ST
D
Borrow 1+r f
at the risk-free rate at t=0 for 1 year −D 0 0
Total payoff 0 K ST

D
where we borrow 1+rf at t=0 for 1 year in order to offset the dividend payment at t=1.
K
The price of the first portfolio at t=0 is C0 + (1+rf )T
. The price of the second portfolio at t=0
D
is P0 + S0 − 1+rf
. Since the two portfolios have the same cash flows at all futures dates, they
should have the same price today:
K D
C0 + = P0 + S0 −
(1 + rf )T 1 + rf

K D
c. C0 + (1+r T = 95.70 and P0 + S0 − 1+rf = 83.71, so the call is over-valued relative to the put.
f)
There is an arbitrage strategy:

t=0 t=1 t=T t=T

if ST < K if ST > K
Sell the call 5 0 100 − ST
100
Borrow 1.05 2 at the risk-free rate at t=0 for 2 years 90.70 −100 −100
Buy the put −8 100 − ST 0
Buy the underlying asset −90 15 ST ST
15
Borrow 1.05 at the risk-free rate at t=0 for 1 year 14.29 −15
Total payoff 11.99 0 0 0

Problem 6

a. The strike price of Put 1 is e110. Therefore it pays nothing in the good state.

b. Put-call parity with Call 2 and Put 1: 4.21 + 110

1.03 = 100 + P implies P = 11 e.

c. Call 1 pays 0 in the bad state and 20 in the good state, i.e., its payoff is twice the payoff of Call
2. Its price is 2 × 4.21 = 8.42 e.

d. Same price.

e. Replicating portfolio with x1 units of stock XYZ and x2 units of Put 1:


12 = 120 x1 + 0
19 = 90 x1 + 20 x2

which gives x1 = 0.1 and x2 = 0.5. The no-arbitrage price is 0.1 × 100 + 0.5 × 11 = 15.5 e.

f. Security ABC is overpriced. Arbitrage strategy: sell short 1 security ABC + buy 0.1 share of
XYZ + buy 0.5 Put

Payoff at t=0 Payoff at t=1

Bad state Good state
Short 1 security ABC +16 −19 −12
Long 0.1 share of stock −10 +9 +12
Long 0.5 put option −5.5 +10 0
Total payoff +0.5 0 0