Finc475 T5 S

Weeks 8&9 - Tutorial Solutions
Problem 10.1.
List the six factors affecting stock option prices.
The six factors affecting stock option prices are the stock price, strike price, risk-free interest
rate, volatility, time to maturity, and dividends.
Problem 10.2.
What is a lower bound for the price of a four-month call option on a non-dividend-paying
stock when the stock price is $28, the strike price is $25, and the risk-free interest rate is 8%
per annum?
The lower bound is

-rT
C >= S0 –Ke
= 28 − 25e−00803333 = $366
Problem 10.3.
What is a lower bound for the price of a one-month European put option on a non-dividend-
paying stock when the stock price is $12, the strike price is $15, and the risk-free interest rate
is 6% per annum?
The lower bound is
-rT
p>= Ke –S0
= 15e−006008333 − 12 = $293
Problem 10.7.
The price of a non-dividend paying stock is $19 and the price of a three-month European call
option on the stock with a strike price of $20 is $1. The risk-free rate is 4% per annum. What
is the price of a three-month European put option with a strike price of $20?
From put–call parity
p = c + Ke− rT − S0
p = 1 + 20e −004025 − 19 = 180
so that the European put price is $1.80.

Problem 10.11.
A four-month European call option on a dividend-paying stock is currently selling for $5. The
stock price is $64, the strike price is $60, and a dividend of $0.80 is expected in one month.
The risk-free interest rate is 12% per annum for all maturities. What opportunities are there
for an arbitrageur?
c + Ke − rT = p + S0 − PVD
According to the put-call parity with dividends, we have:
Because p>=0 (price of put option)

= c = p + S0 − PVD − Ke − rT
The present value of the dividend is 080e−012112 = 079
Therefore,
= c  S0 − PVD − Ke −rT = 64 − 57.65 − 0.79 = 5.56
However, the price of the call in the market = 5, so the call is underpriced because it is cheaper in
comparison with the theoretical no-arbitrage price.
Problem 10.12.
A one-month European put option on a non-dividend-paying stock is currently selling for

$250 . The stock price is $47, the strike price is $50, and the risk-free interest rate is 6% per
annum. What opportunities are there for an arbitrageur?
According to the put-call parity with dividends, we have:
𝒄 + 𝑲𝒆−𝒓𝑻 = 𝒑 + 𝑺𝟎
Because c>=0 (price of call option)
𝑝 >= 𝑐 + 𝐾𝑒 −𝑟𝑇 − 𝑆0
𝑃 >= 0 + 50𝑒 −0.06×1/12 − 47 = 2.75
However, the price of the put in the market = 2.5, so the call is underpriced because it is cheaper
in comparison with the theoretical no-arbitrage price.
Problem 10.8.
Explain why the arguments leading to put–call parity for European options cannot be used to
give a similar result for American options.
When early exercise is not possible, we can argue that two portfolios that are worth the same at
time T must be worth the same at earlier times. When early exercise is possible, the argument
falls down.
Problem 10.4.
Give two reasons that the early exercise of an American call option on a non-dividend-paying
stock is not optimal. The first reason should involve the time value of money. The second
reason should apply even if interest rates are zero.
1) Delaying exercise delays the payment of the strike price. This means that the option holder is
able to earn interest on the strike price for a longer period of time.
2) Delaying exercise also provides insurance against the stock price falling below the strike price by
the expiration date.
Problem 10.14.
The price of a European call that expires in six months and has a strike price of $30 is $2. The
underlying stock price is $29, and a dividend of $0.50 is expected in two months and again in
five months. The term structure is flat, with all risk-free interest rates being 10%. What is the
price of a European put option that expires in six months and has a strike price of $30?
Using the notation in the chapter, put-call parity [equation (10.10)] gives
c + Ke− rT + D = p + S0
or
p = c + Ke− rT + D − S0
In this case
p = 2 + 30e −016 12 + (05e −012 12 + 05e −01512 ) − 29 = 251
In other words the put price is $2.51.

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Weeks 8&9 - Tutorial Solutions

List the six factors affecting stock option prices.

The lower bound is

The lower bound is

From put–call parity

p = 1 + 20e −004025 − 19 = 180

so that the European put price is $1.80.

Because p>=0 (price of put option)

The present value of the dividend is 080e−012112 = 079

A one-month European put option on a non-dividend-paying stock is currently selling for

According to the put-call parity with dividends, we have:

Because c>=0 (price of call option)

𝑃 >= 0 + 50𝑒 −0.06×1/12 − 47 = 2.75

p = 2 + 30e −016 12 + (05e −012 12 + 05e −01512 ) − 29 = 251

In other words the put price is $2.51.

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