Chapter 20 - Options Markets: Introduction

CHAPTER20:OPTIONSMARKETS:INTRODUCTION
PROBLEMSETS
1.

[Link]
simplestexampleofanoptionstrategythatincreasesriskisinvestinginanalloptions
portfolioofatthemoneyoptions(asillustratedinthetext).Theleverageprovidedby
optionsmakesthisstrategyveryrisky,[Link]
[Link],theinvestorbuysaput
onanexistingstockorportfolio,withexercisepriceoftheputnearorsomewhatless
[Link]
portfoliobecausetheminimumvalueofthestockplusputstrategyistheexerciseprice
oftheput.

2.

Buyingaputoptiononanexistingportfolioprovidesportfolioinsurance,whichis
[Link]
value,theminimumvalueoftheputplusstockstrategyistheexercisepriceoftheput.
Aswithanyinsurancepurchasedtoprotectthevalueofanasset,thetradeoffaninvestor
[Link]
theprotectionisthecostofacquiringtheprotectiveput,whichreducestheprofitthat
resultsshouldtheportfolioincreaseinvalue.

3.

[Link],at
expiration,thevalueoftheportfolioexceedstheexercisepriceofthecall,thewriterof
thecoveredcallcanexpectthecalltobeexercised,sothatthewriterofthecallmust
[Link],ifthevalueoftheportfolioisless
thantheexerciseprice,thewriterofthecallkeepsboththeportfolioandthepremium
[Link]
premiumincomereceivedversusforfeitofanypossiblecapitalappreciationabovethe
exercisepriceofthecall.

20-1

Chapter 20 - Options Markets: Introduction

4.

[Link]
optionisoutofthemoneywhenthemarketpriceoftheunderlyingstockislessthanthe
[Link]
price,thenthelikelihoodthattheoptionwillbeexercisedislow,andfluctuationsinthe
[Link]
sensitivityoftheoptionpricetochangesinthepriceofthestockiscalledtheoptions
delta,[Link]
money,[Link],thereisgenerallylittletobegainedorlost
bybuyingorwritingacallthatisfaroutofthemoney.(Asimilarresultappliestoaput
optionthatisfaroutofthemoney,withstockpricesubstantiallygreaterthanexercise
price.)
Acallisinthemoneywhenthemarketpriceofthestockisgreaterthantheexercise
[Link],thenthe
[Link],
sincesuchanoptionisverylikelytobeexercised,thesensitivityoftheoptionpriceto
changesinstockpriceapproachesone,indicatingthata$1increaseinthepriceofthe
stockresultsina$[Link],the
buyerofanoptionlosesthebenefitoftheleverageprovidedbyoptionsthatarenearthe
[Link],thereislittleinterestinoptionsthatarefarintothemoney.

5.
a.
b.
c.
d.
e.
f.
6.

Calloption,X=$100.00
Putoption,X=$100.00
Calloption,X=$105.00
Putoption,X=$105.00
Calloption,X=$110.00
Putoption,X=$110.00

Cost
$7.65
$2.53
$4.40
$4.40
$2.30
$7.40

Payoff
$5.00
$0.00
$0.00
$0.00
$0.00
$5.00

Profit
$2.65
$2.53
$4.40
$4.40
$2.30
$2.40

Intermsofdollarreturns,basedona$10,000investment:
StockPrice
Allstocks(100shares)
Alloptions(1,000options)
Bills+100options

PriceofStock6MonthsfromNow
$80
$100
$110
$120
$8,000 $10,000 $11,000 $12,000
$0
$0
$10,000 $20,000
$9,360 $9,360 $10,360 $11,360

Intermsofrateofreturn,basedona$10,000investment:
StockPrice
Allstocks(100shares)
Alloptions(1,000options)

PriceofStock6MonthsfromNow
$80
$100
$110
$120
20%
0%
10%
20%
100%
100%
0%
100%
20-2

Chapter 20 - Options Markets: Introduction

Bills+100options

6.4%

6.4%

20-3

3.6%

13.6%

Chapter 20 - Options Markets: Introduction

All options
All stocks
Bills plus options

100

110

6.4

ST

100

7.

a.

Fromputcallparity:
P=CS0+[X/(1+rf)T]=10100+[100/(1.10)1/4]=$7.65

b. Purchaseastraddle,i.e.,[Link]
straddleis:$10+$7.65=$17.65
Thisistheamountbywhichthestockwouldhavetomoveineitherdirectionfor
theprofitonthecallorputtocovertheinvestmentcost(notincludingtimevalue
ofmoneyconsiderations).Accountingfortimevalue,thestockpricewouldhave
tomoveineitherdirectionby:$17.651.101/4=$18.08
8.

a.

Fromputcallparity:
C=P+S0[X/(l+rf)T]=4+50[50/(1.10)1/4]=$5.18

b.

Sellastraddle,i.e.,sellacallandaputtorealizepremiumincomeof:
$5.18+$4=$9.18
Ifthestockendsupat$50,bothoftheoptionswillbeworthlessandyourprofit
willbe$[Link],atanyotherstock
price,[Link]
moveby$9.18ineitherdirectionbeforeyourprofitsbecomenegative.

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Chapter 20 - Options Markets: Introduction

c.

Buythecall,sell(write)theput,lend:$50/(1.10)1/4
Thepayoffisasfollows:
Position

ImmediateCF

Call(long)
Put(short)

C=5.18
P=4.00
50
48.82
Lendingposition
1.101 / 4
CP+
50
Total
50.00
1.101 / 4

CFin3months
STX
ST>X
0
ST50
(50ST)
0
50

50

ST

ST

Bytheputcallparitytheorem,theinitialoutlayequalsthestockprice:
S0=$50
Ineitherscenario,youendupwiththesamepayoffasyouwouldifyouboughtthe
stockitself.
9.

a.

b.

Outcome
Stock
Put
Total

STX
ST+D
XST
X+D

ST>X
ST+D
0
ST+D

Outcome
Call
Zeros
Total

STX
0
X+D
X+D

ST>X
STX
X+D
ST+D

ThetotalpayoffsforthetwostrategiesareequalregardlessofwhetherSTexceeds
X.
c.

Thecostofestablishingthestockplusputportfoliois:S0+P
Thecostofestablishingthecallpluszeroportfoliois:C+PV(X+D)
Therefore:
S0+P=C+PV(X+D)
Thisresultisidenticaltoequation20.2.

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Chapter 20 - Options Markets: Introduction

10.

a.
ST<X1

X1STX2

X2<STX3

X3<ST

Longcall(X1)
Short2calls(X2)
Longcall(X3)

0
0
0

STX1
0
0

STX1
2(STX2)
0

STX1
2(STX2)
STX3

Total

STX1

2X2X1ST

(X2X1)(X3X2)=0

Position

Payof
X2 X1

X1

X2

ST

X3

b.
Position

ST<X1

Buycall(X2)
Buyput(X1)

0
X1ST

Total

X1ST

X1STX2
X2X2XX
2
0

X2<ST

STX2
0

STX2

Payof
X1

X1

ST

X2

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Chapter 20 - Options Markets: Introduction

11.
ST<X1

X1STX2

X2<ST

Buycall(X2)
Sellcall(X1)

0
0

XX
02
(STX1)

STX2
(STX1)

Total

X1ST

X1X2

X1

X2

Position

Payof
0

Payof

(X2 X1)

12.

a.

ST

Bywritingcoveredcalloptions,Jonesreceivespremiumincomeof$30,[Link],in
January,thepriceofthestockislessthanorequalto$45,thenJoneswillhavehis
[Link]($450,000
+$30,000)becausethestockwillbecalledawayfromhimifthestockprice
exceeds$45.(Weareignoringhereanyinterestearnedoverthisshortperiodof
timeonthepremiumincomereceivedfromwritingtheoption.)Thepayoff
structureis:
Stockprice
lessthan$45
greaterthan$45

Portfoliovalue
10,000timesstockprice+$30,000
$450,000+$30,000=$480,000

ThisstrategyofferssomeextrapremiumincomebutleavesJonessubjectto
[Link],ifthestockpricefelltozero,Jones
wouldbeleftwithonly$30,[Link]
$480,000,butthisismorethansufficienttopurchasethehouse.
b.

Bybuyingputoptionswitha$35strikeprice,Joneswillbepaying$30,000in
premiumsinordertoinsureaminimumlevelforthefinalvalueofhisposition.
Thatminimumvalueis:($3510,000)$30,000=$320,000
Thisstrategyallowsforupsidegain,butexposesJonestothepossibilityofa
[Link]:
Stockprice
lessthan$35
greaterthan$35

Portfoliovalue
$350,000$30,000=$320,000
10,000timesstockprice$30,000

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Chapter 20 - Options Markets: Introduction

c.

[Link]:
Stockprice
lessthan$35
between$35and$45
greaterthan$45

Portfoliovalue
$350,000
10,000timesstockprice
$450,000

Ifthestockpriceislessthanorequalto$35,thenthecollarpreservesthe
$350,[Link]$45,thenJonesgainsuptoacapof
$450,[Link]$35and$45,hisproceedsequal10,000timesthestock
price.
Thebeststrategyinthiscasewouldbe(c)sinceitsatisfiesthetworequirements
ofpreservingthe$350,000inprincipalwhileofferingachanceofgetting
$450,[Link](a)shouldberuledoutsinceitleavesJonesexposedtothe
riskofsubstantiallossofprincipal.
Ourrankingwouldbe:(1)strategyc;(2)strategyb;(3)strategya.
13.

a.,b. TheExcelspreadsheetforbothparts(a)and(b)isshownonthenextpage,andthe
profitdiagramsareonthefollowingpage.

14.

Thefarmerhastheoptiontosellthecroptothegovernmentforaguaranteedminimum
[Link]
pricePmthenthefarmerhasaputoptiontosellthecrop(theasset)atanexerciseprice
ofPSevenifthepriceoftheunderlyingasset(Pm)islessthanPS.

15.

Thebondholdershave,ineffect,madealoanwhichrequiresrepaymentofBdollars,
[Link],however,thevalueofthefirm(V)islessthanB,
[Link],the
bondholdersareforcedtopayB(inthesensethattheloaniscancelled)inreturnfor
[Link]
[Link],onemightviewthebondholdersasgivingtheright
[Link]
bondholdershaveissuedacalltotheequityholders.

16.

Themanagerreceivesabonusifthestockpriceexceedsacertainvalueandreceives
[Link].

20-8

Chapter 20 - Options Markets: Introduction

SpreadsheetforProblem13:
Stock Prices
Beginning Market Price
Ending Market Price

116.5
130
Ending

Buying Options:
Call Options Strike
110
120
130
140

Price
22.80
16.80
13.60
10.30

Payoff
20.00
10.00
0.00
0.00

Profit
-2.80
-6.80
-13.60
-10.30

Return %
-12.28%
-40.48%
-100.00%
-100.00%

Put Options Strike

Price
12.60
17.20
23.60
30.50

Payoff
0.00
0.00
0.00
10.00

Profit
-12.60
-17.20
-23.60
-20.50

Return %
-100.00%
-100.00%
-100.00%
-67.21%

Straddle
110
120
130
140

Price
35.40
34.00
37.20
40.80

Payoff
20.00
10.00
0.00
10.00

Profit
-15.40
-24.00
-37.20
-30.80

Return %
-43.50%
-70.59%
-100.00%
-75.49%

20-9

Stock Price
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210

X 130 Straddle
Profit
-37.20
42.80
32.80
22.80
12.80
2.80
-7.20
-17.20
-27.20
-37.20
-27.20
-17.20
-7.20
2.80
12.80
22.80
32.80
42.80

Chapter 20 - Options Markets: Introduction

Selling Options:
Call Options Strike
110
120
130
140

Price
22.80
16.80
13.60
10.30

Payoff
-20
-10
0
0

Profit
2.80
6.80
13.60
10.30

Return %
12.28%
40.48%
100.00%
100.00%

110
120
130
140

Price
12.60
17.20
23.60
30.50

Payoff
0
0
0
10

Profit
12.60
17.20
23.60
40.50

Return %
100.00%
100.00%
100.00%
132.79%

Price

Payoff

Profit

16.80
13.60

10.00
0
10.00

Put Options Strike

Money Spread
Bullish Spread
Purchase 120 Call
Sell 130 Call
Combined Profit

-6.80
13.60
6.80

Ending
Stock Price
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210

Bullish
Spread

Profitdiagramforproblem13:
Spreads and Straddles
50.00

40.00

30.00

20.00

130 Straddle

10.00

Bullish Spread
0.00
0

50

100

150

-10.00

-20.00

-30.00

-40.00

-50.00

Stock Price

20-10

200

250

6.80
-3.2
-3.2
-3.2
-3.2
-3.2
-3.2
-3.2
-3.2
6.8
6.8
6.8
6.8
6.8
6.8
6.8
6.8
6.8

Chapter 20 - Options Markets: Introduction

17.

a.
Position
Writecall,X=$105
Writeput,X=$100
Total

ST<100

100ST105

ST>105

0
(100ST)

0
0

(ST105)
0

ST100

105ST

Payof
100

105

ST

Write put

b.

Write call

Proceedsfromwritingoptions:
Call:
$4.40
Put:
$2.53
Total: $6.93
IfIBMsellsat$103ontheoptionexpirationdate,bothoptionsexpireoutofthe
money,andprofit=$[Link]$110ontheoptionexpirationdate,the
callwrittenresultsinacashoutflowof$5atexpiration,andanoverallprofitof:
$6.93$5.00=$1.93

c.

Youbreakevenwheneithertheputorthecallresultsinacashoutflowof$6.93.
Fortheput,thisrequiresthat:
$6.93=$100.00STST=$93.07
Forthecall,thisrequiresthat:
$6.93=ST$105ST=$111.93

d.

[Link]
issimilartoastraddle.

20-11

Chapter 20 - Options Markets: Introduction

18.

[Link],thenetoutlayto
establishtheportfolioispositive.
Position
Writeput,X=$90
Buyput,X=$95
Total

ST<90

90ST95

ST>95

(90ST)
95ST

0
95ST

0
0

95ST

Thepayoffandprofitdiagramis:

19.

BuytheX=62put(whichshouldcostmorebutdoesnot)andwritetheX=60put.
Sincetheoptionshavethesameprice,[Link]
expirationmaybepositive,butcannotbenegative.
Position
Buyput,X=$62
Writeput,X=$60
Total

ST<60

60ST62

ST>62

62ST
(60ST)

62ST
0

0
0

62ST

Payof = Profit (because net investment = 0)

0
60

ST

62

20-12

Chapter 20 - Options Markets: Introduction

20.

ThefollowingpayofftableshowsthattheportfolioisrisklesswithtimeTvalueequalto
$10:
Position

ST10

ST>10

Buystock
Writecall,X=$10
Buyput,X=$10

ST
0
10ST

ST
(ST10)
0

10

10

Total

Therefore,theriskfreerateis:($10/$9.50)1=0.0526=5.26%
21.

a.,b.
Position
Buyput,X=$110
Writeput,X=$100
Total

ST<100

100ST110

ST>110

110ST
(100ST)

110ST
0

0
0

10

110ST

[Link]
exercisepricethantheputyouwrite,andthereforemustcostmorethantheput
[Link],netprofitswillbelessthanthepayoffattimeT.
10
Payof
0
100
c.

110

ST
Profit

[Link],its
betaisnegative.

20-13

Chapter 20 - Options Markets: Introduction

22.

a.

Joesstrategy
Position

Cost

Payoff
ST400

ST>400

Stockindex
Putoption,X=$400

400
20

ST
400ST

ST
0

Total

420

400

ST

20

ST420

Profit=payoff$420
Sallysstrategy
Position

Cost

Payoff
ST390

ST>390

Stockindex
Putoption,X=$390

400
15

ST
390ST

ST
0

Total

415

390

ST

25

ST415

Profit=payoff$415
Profit

Sally
390

400

Joe
ST

-20
-25

b.

Sallydoesbetterwhenthestockpriceishigh,butworsewhenthestockpriceis
[Link]=$395,whenbothpositionsprovidelosses
of$20.

c.

[Link]
thestockindex.

20-14

Chapter 20 - Options Markets: Introduction

23.

a.,b. (Seegraphbelow)
[Link]=$9$3=$6
Thepayoffiseithernegativeorzero:
ST<50

50ST60

ST>60

Buycall,X=$60
Writecall,X=$50

0
0

0
(ST50)

ST60
(ST50)

Total

(ST50)

10

Position

c.

Breakevenoccurswhenthepayoffoffsetstheinitialproceedsof$6,whichoccurs
atstockpriceST=$[Link]:thepositiondoesworse
whenthestockpriceincreases.

24.

60

50

ST

-4

Profit

-10

Payof

Buyashareofstock,writeacallwithX=$50,writeacallwithX=$60,andbuyacall
withX=$110.
ST<50

50ST60

60<ST110

ST>110

Buystock
Writecall,X=$50
Writecall,X=$60
Buycall,X=$110

ST
0
0
0

ST
(ST50)
0
0

ST
(ST50)
(ST60)
0

ST
(ST50)
(ST60)
ST110

Total

ST

50

110ST

Position

[Link]
thestockpriceSTisbetween$50and$60.

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Chapter 20 - Options Markets: Introduction

25.

a.
Position

ST780

ST>780

Buystock
Buyput

ST
780ST

ST
0

780

ST

ST840

ST>840

Buycall
BuyTbills

0
840

ST840
840

Total

840

ST

Total
Position

Payof
Bills plus calls
840
780

Protective put strategy

ST

b.

780
840
ThebillspluscallstrategyhasagreaterpayoffforsomevaluesofSTandnevera
[Link]
greater,itmustbemorecostlytopurchase.

20-16

Chapter 20 - Options Markets: Introduction

c.

Theinitialcostofthestockplusputpositionis:$900+$6=$906
Theinitialcostofthebillspluscallpositionis:$810+$120=$930
Stock
+Put
Payoff
Profit

ST=700
700
80
780
126

ST=840
840
0
840
66

ST=900
900
0
900
6

ST=960
960
0
960
54

840
0
840
90

840
0
840
90

840
60
900
30

840
120
960
+30

Bill
+Call
Payoff
Profit
Profit

Protective put
Bills plus calls
780

840

ST

-90
-126

26.

d.

[Link]
[Link],itsbetaishigher.

e.

[Link]
appliesonlytoputsandcallswiththesameexercisepriceandexpirationdate.

Accordingtoputcallparity(assumingnodividends),thepresentvalueofapaymentof
$105canbecalculatedusingtheoptionswithFebruaryexpirationandexercisepriceof
$105.
PV(X)=S0+PC
PV($105)=$104.69+$4.40$4.40=$104.69

27.

Fromputcallparity:
CP=S0X/(l+rf)T
Iftheoptionsareatthemoney,thenS0=Xand:
CP=XX/(l+rf)T
Therighthandsideoftheequationispositive,andweconcludethatC>P.
20-17

Chapter 20 - Options Markets: Introduction

CFAPROBLEMS
1.

a.

[Link]
consistsofbuyingaputandacallwiththesameexpirationdateandthesame
underlyingasset,[Link],thecallhasan
exercisepriceabovethestockpriceandtheputhasanexercisepricebelowthe
[Link](goeslong)astrangleexpectsthatthepriceof
theunderlyingasset(TRTMaterialsinthiscase)willeithermovesubstantially
[Link]
respecttoTRT,thelongstrangleinvestorbuysboththeputoptionandthecall
optionforatotalcostof$9.00,andwillexperienceaprofitifthestockprice
movesmorethan$9.00abovethecallexercisepriceormorethan$9.00belowthe
[Link]'sclienttoprofitfromalarge
moveinthestockprice,eitherupordown,inreactiontotheexpectedcourt
decision.

b.

[Link]$9.00,whichisthetotalcostofthetwo
options($5.00+$4.00).
[Link]
breakevenrangeofprices.
[Link]$46.00and$[Link]
stockpricefinishes$9.00belowtheputexerciseprice
(i.e.,$55$9=$46),andthecallwilljustcovercostsifthestockpricefinishes
$9.00abovethecallexerciseprice(i.e.,$60+$9=$69).

2.

i.

Equityindexlinkednote:Unliketraditionaldebtsecuritiesthatpayascheduled
rateofcouponinterestonaperiodicbasisandtheparamountofprincipalat
maturity,theequityindexlinkednotetypicallypayslittleornocouponinterest;at
maturity,however,aunitholderreceivestheoriginalissuepriceplusa
supplementalredemptionamount,thevalueofwhichdependsonwheretheequity
indexsettledrelativetoapredeterminedinitiallevel.

ii.

Commoditylinkedbearbond:Unliketraditionaldebtsecuritiesthatpaya
scheduledrateofcouponinterestonaperiodicbasisandtheparamountof
principalatmaturity,thecommoditylinkedbearbondallowsaninvestorto
[Link]
marketcoupon,buyersofabeartranchereceivearedemptionvaluethatexceeds
thepurchasepriceifthecommoditypricehasdeclinedbythematuritydate.

20-18

Chapter 20 - Options Markets: Introduction

3.

i.

Conversionvalueofaconvertiblebondisthevalueofthesecurityifitis
[Link]:
Conversionvalue=
marketpriceofthecommonstockconversionratio=
$4022=$880

ii.

Marketconversionpriceisthepricethataninvestoreffectivelypaysforthe
commonstockiftheconvertiblebondispurchased:
Marketconversionprice=
marketpriceoftheconvertiblebond/conversionratio=
$1,050/22=$47.73

4.

a.

[Link]:
Marketconversionprice=
marketpriceoftheconvertiblebond/conversionratio=
$980/25=$39.20
[Link]:
Expectedreturn=[(endofyearprice+coupon)/currentprice]1
=[($1,125+$40)/$980]1=0.1888=18.88%
[Link]:
Expectedreturn=[(endofyearprice+dividend)/currentprice]1
=($45/$35)1=0.2857=28.57%

b.

Thetwocomponentsofaconvertiblebondsvalueare:

thestraightbondvalue,whichistheconvertiblebondsvalueasabond,and;

theoptionvalue,whichisthevalueassociatedwiththepotentialconversion
intoequity.

(i.)InresponsetotheincreaseinYtelscommonequityprice,thestraightbond
valueshouldstaythesameandtheoptionvalueshouldincrease.
The increase in equity price does not affect the straight bond value component of
the Ytel convertible. The increase in equity price increases the option value
component significantly, because the call option becomes deep in the money
when the $51 per share equity price is compared to the convertibles conversion
price of: $1,000/25 = $40 per share.

20-19

Chapter 20 - Options Markets: Introduction

(ii.)Inresponsetotheincreaseininterestrates,thestraightbondvalueshould
decreaseandtheoptionvalueshouldincrease.
Theincreaseininterestratesdecreasesthestraightbondvaluecomponent(bond
valuesdeclineasinterestratesincrease)oftheconvertiblebondandincreasesthe
valueoftheequitycalloptioncomponent(calloptionvaluesincreaseasinterest
ratesincrease).Thisincreasemaybesmallorevenunnoticeablewhencompared
tothechangeintheoptionvalueresultingfromtheincreaseintheequityprice.

5.

a.

(ii)

b.

(i)

[Profit=$40$25+$2.50$4.00]

20-20