PROBLEM 1
1. You own a call option on Intuit stock with a strike price of $40. The option
will expire in exactly three months’ time.
a. If the stock is trading at $55 in three months, what will be the payoff of
the call?
• K = the exercise price = $40
• S = the stock price at expiration = $55
• C = value of the call option at expiration
Ø C = max (S – K, 0) = max (55 – 40, 0) = $15
b. If the stock is trading at $35 in three months, what will be the payoff of
the call?
• K = the exercise price = $40
• S = the stock price at expiration = $35
• C = value of the call option at expiration
Ø C = max (35 – 40, 0) = $0 à we don’t exercise the call option because
we will lose $5 (we will pay $40 for an underlying asset that is worth $35)
c. Draw a payoff diagram showing the value of the call at expiration as a
function of the stock price at expiration.
Long call option
18
15
12
Payoff ($)
9
6
3
0
0 S = 35 K = 40 S = 55
Stock Price ($)
Payoff
2. Assume that you have shorted the call with the above characteristics
a. If the stock is trading at $55 in three months, what will you owe?
If we short/sell a call option for $40 and it is worth $55 at expiration, we owe
$15.
b. If the stock is trading at $35 in three months, what will you owe?
If the stock price at expiration date (S) < exercise price (K) à buyer doesn’t
exercise, thus we owe nothing.
c. Draw a payoff diagram showing the amount you owe at expiration as a
function of the stock price at expiration.
Short call option
0 $40
0
-3
-6
Payoff ($)
-9
-12
-15
-18
Stock Price ($)
Payoff
3. You own a put option on Ford stock with a strike price of $10. The option
will expire in exactly six months’ time
a. If the stock is trading at $8 in six months, what will be the payoff of the
put?
• K = the exercise price = $10
• S = the stock price at expiration = $8
• P = value of a put option at expiration
Ø P = max (K – S, 0) = max (10 – 8, 0) = $2 à we exercise the sell option,
and we get $2
b. If the stock is trading at $23 in six months, what will be the payoff of
the put?
• K = the exercise price = $10
• S = the stock price at expiration = $23
• P = value of a put option at expiration
Ø Put = max (K – S, 0) = max (10 – 23, 0) = $0 à we don’t exercise the put
option because we will lose $13
c. Draw a payoff diagram showing the value of the put at expiration as a
function of the stock price at expiration.
Long put option
15
10
Payoff ($)
0
0 S=8 K = 10 S = 23
Stock Price ($)
4. Assume that you have shorted the put with the above characteristics.
a. If the stock is trading at $8 in three months, what will you owe?
If we short a put option for $10 when it is worth $8 at expiration, we owe $2
b. If the stock is trading at $23 in three months, what will you owe?
If K < S à we owe $0 since no one will exercise the option
c. Draw a payoff diagram showing the amount you owe at expiration as a
function of the stock price at expiration.
Short put option
0 S=8 K = 10 S = 23
0
-2
Payoff ($)
-4
-6
-8
-10
Stock Price ($)
PROBLEM 2
Dynamic Energy Systems stock is currently trading for $33 per share. The stock
pays no dividends. A one-year European put option on Dynamic with a strike
price of $35 is currently trading for $2.10. If the risk-free interest rate is 10% per
year, what is the price of a one-year European call option on Dynamic with a
strike price of $35?
• !! = risk-free interest rate = 10%
• S = current stock price = 33
• P = put price = 2.10
• K = strike price of the option = 35
• C = call price
We know that for a European call option without dividend-paying, Put-Call Parity:
S + P = PV(K) + C
12
" = % + ' – %)(+) = -. /0 + 11 – = $1. -4
/. /
PROBLEM 3
You happen to be checking the newspaper and notice an arbitrage opportunity.
The current stock price of Intrawest is $20 per share and the one-year risk-free
interest rate is 8%. A one year put on Intrawest with a strike price of $18 sells for
$3.33, while the identical call sells for $7. Explain what you must do to exploit
this arbitrage opportunity.
• !! = 8%
• S = stock price = 20
• P = put price = 3.33
• K = strike price of the option = 18
• C = call price = 7
According to the Put-Call Parity, we have:
S + P = PV(K) + C
/4
" = % + ' – %)(+) = 1. 11 + -0 – = $5. 55 < $7
/. 04
The call is overpriced in comparison with the portfolio (S + P – PV(K)) as its price is
higher. The strategy could be to sell the call option, buy the put, buy the stock, and
!"
borrow $16.67 which represents the present value of 18 → !.$"
Ø Therefore, the profit would be $7 – $6.66 = $0.33 with no cash flows when the
options expire.
PROBLEM 4
Create the payoff profile of butterfly spread by using only put options.
A butterfly spread with put options is a portfolio with two long put options (sell) with
different strike prices and two short put options (buy) with a strike price that is equal to
the average strike price of the first two puts.
Therefore, a butterfly spread with put options is a strategy divided in 3 steps:
• Step 1: one long put at K3
• Step 2: two short puts at K2
• Step 3: one long put at K1
Ø With K1 < K2 < K3
ð As we can see in the graphical example, investors having this type of
portfolio are hoping that the stock price stays between the lower (K1) and
upper (K3) strike prices. However, if the stock price increases or declines
too much a loss will occur.
PROBLEM 5
Draw the payoff profile of the following portfolio: long position in the underlying
asset, short position in a call with strike price K2, long position in a put with
strike price K1 where we have K1 < K2. This payoff profile is typically called a
collar. What are the incentives of the buyer of such a portfolio?
By having a long position in the underlying asset protects the investor in case of
downside. Thus, buying a put protects the stock until its expiration. It reduces the
volatility and allows the investors to make profits when the market goes up. Although,
it can be seen as buying an “insurance”, buying a put is expensive. The strategy to
overcome this cost is to sell a call. But doing this means we agree to lose some of the
advantages provided by a long position.
Graphical example for this portfolio:
Collar
3,5
2,5
1,5
Payoff ($)
0,5
0
0 K1 K2 St
-0,5
-1
-1,5
Stock Price ($)
Long asset/stock short call long put composed
PROBLEM 6
Wesley Corp. stock is trading for $25/share. Wesley has 20 million shares
outstanding and a market debt equity ratio of 0.5. Wesley’s debt is zero coupon
debt with a 5-year maturity and a yield to maturity of 10%.
• Shares outstanding = 20 million
• S = $25/share
• Debt-to-equity ratio = 0.5
• YTM = 0.1
A. Describe Wesley’s equity as a call option. What is the maturity of the call
option? What is the market value of the asset underlying this call option?
What is the strike price of this call option?
- The maturity of the option is in 5 years.
- The market value of the asset is $750 million
ð A = E + D = 25 × 20 + 0.5 × (25 × 20) = 500 + 250 = $750m
- Strike price = D = $250 million
ð The strike price is equivalent to the debt as we can see above and on
the graphical representation
Graphical illustration:
Equity as a call option
1,5
Equity value ($)
0,5
0
0 D V
Firm Asset Value ($)
Equity as a call option
Ø D represents the value of debt, if V > D, so there is enough money left to repay
creditors and what is left will be for equity holders.
B. Describe Wesley’s debt using a call option.
- The maturity of the option is in 5 years.
- The market value of the asset is $750 million
ð A = E + D = 25 × 20 + 0.5 × (25 × 20) = 500 + 250 = $750m
- Strike price = E = $500 million
Ø Short the equity call and long the value of the underlying asset of the firm.
Graphical illustration:
Debt as a call option
1,5
1
value ($)
0,5
0
0 E V
Firm Asset Value ($)
Debt as a call option
C. Describe Wesley’s debt using a put option.
Long the risk-free debt and get a short put option in the underlying asset with 5
years maturity and a face value of $250 million.
Graphical illustration:
Debt as a put option
1,5
0,5
Value ($)
0
0 D = 250 Firm Value V
-0,5
-1
-1,5
Firm Asset Value ($)
Debt as put option (composed) Long risk free debt Put option