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    10) Options Solutions To Practice Questions

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    Laiba Raza

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    10) Options Solutions To Practice Questions

    Uploaded by

    Laiba Raza
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    10) Options Solutions to Practice Questions

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    4 views3 pages

    10) Options Solutions To Practice Questions

    Uploaded by

    Laiba Raza

    Copyright:

    © All Rights Reserved
    Download as DOC, PDF, TXT or read online from Scribd
    Download as doc, pdf, or txt
    of 3

    Options: Solutions to Practice Questions

    Question One
    MIM stock is currently trading at $1.76 per share. European put and call options
    struck at $1.65 and maturing three months from today are trading at $0.05 and $0.17
    respectively. The riskless interest rate is 5.0% p.a. Is there an arbitrage opportunity
    in this market? If so, construct a table and illustrate that the riskless profit is locked
    in whether the stock price is $1.00 or $2.00 at maturity.

    In this case, put-call parity is violated since c = 0.17 < p + So – X(1 + rf)–T = 0.18. The
    violation occurs because of any one or all of the following possibilities:

    • The call is underpriced;


    • The put is overpriced; and / or,
    • The stock is overpriced.

    The arbitrage portfolio therefore must account for all three of these
    possibilities simultaneously. Consider the following portfolio:

    Value at Maturity
    Position Initial Value If ST=1.00 If ST=2.00
    Buy European Call -0.17 0 2.00-1.65
    Sell European Put 0.05 -(1.65-1.00) 0
    Short-Sell Stock 1.76 -1.00 -2.00
    Lend 1.65(1.05)-0.25 -1.63 1.65 1.65
    Net Portfolio Value 0.01 0 0

    In forming the portfolio described above, a certain arbitrage profit of $0.01 is earned
    immediately. Note that we buy the call (the left hand side of the put-call parity
    equation) since it is relatively undervalued. We sell the portfolio on the right hand
    side of the equation since it is relatively overvalued. This involves selling the stock
    and the put. With the excess funds, we buy the bond (equivalent to lending an amount
    equal to the present value of the strike price). The remainder is our profit

    1
    Question Two
    How would your answer to Question One change if the call was trading at $0.20?

    Again, put-call parity would be violated.

    However, now c = 0.20 > p + S0 – X(1 + rf)–T = 0.18. The violation occurs because of
    any one or all of the following possibilities:

    • The call is overpriced;


    • The put is underpriced; and / or,
    • The stock is underpriced.

    The arbitrage portfolio therefore must account for all three of these possi bilities
    simultaneously. Consider the following portfolio:

    Value at Maturity
    Position Initial Value If ST=1.00 If ST=2.00
    Sell European Call 0.20 0 -(2.00-1.65)
    Buy European Put -0.05 (1.65-1.00) 0
    Buy Stock -1.76 1.00 2.00
    Borrow 1.65(1.05)-0.25 1.63 -1.65 -1.65
    Net Portfolio Value 0.02 0 0

    In forming the portfolio described above, a certain arbitrage profit of $0.02 is earned
    immediately. Note that we sell the call (the left hand side of the put-call parity
    equation) since it is relatively overvalued. We buy the portfolio on the right hand side
    of the equation since it is relatively undervalued. This involves buying the stock and
    the put. To fund the extra outflow, we sell the bond (equivalent to borrowing an
    amount equal to the present value of the strike price). The remainder is our profit

    Question Three
    Suppose an American call option on Commonwealth Bank stock struck at $13.00 is
    currently selling for $0.20 and the stock price is $13.30. How can a straightforward
    arbitrage be executed?

    Buy the call and exercise immediately. The call costs $0.20 and exercising requires a
    payment of the strike price of $13.00. The total cost of acquiring a CBA share in this
    way is $13.20. The CBA share can then be sold for $13.30, yielding an immediate
    arbitrage profit of $0.10 per share.

    2
    Question Four
    Suppose that an American put option on Coca-Cola Amatil with an exercise price of
    $10.00 is selling for $0.40 and that the Coca-Cola Amatil stock price is $9.50. How
    can a straightforward arbitrage be executed?

    An arbitrage can be executed by buying the option, buying the stock, and immediately
    exercising the option. The cost of the option and the stock is $9.90 per share, and each
    share is sold for $10.00 when the put option is exercised, yielding an immediate profit
    of $0.10 per share.

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