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Financial Options Tutorial Answers

The document discusses financial options, detailing the costs and payoffs associated with buying and selling call and put options. It explains the calculations for costs, payoffs, and net gains or losses based on different share prices at expiration. Additionally, it covers the concept of put-call parity and its implications for transaction costs and option pricing.

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Charles Cheng
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8 views6 pages

Financial Options Tutorial Answers

The document discusses financial options, detailing the costs and payoffs associated with buying and selling call and put options. It explains the calculations for costs, payoffs, and net gains or losses based on different share prices at expiration. Additionally, it covers the concept of put-call parity and its implications for transaction costs and option pricing.

Uploaded by

Charles Cheng
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Tutorial Answers - Financial Options

Q1.
(a) if you buy option contract, ask/buy price is relevant to your transaction because it is the price at
which you could buy an option. Meantime, you could buy the underlying asset (e.g., stock) on or before
the expiration date if you own a call option contract.

For each share, the ask price for the April call option with an exercise price of €51.50 is €0.65.
Because each contract is for 100 shares, if you buy 20 contracts, the total cost is:

Cost = 20×100 shares per contract×€0.65


Cost = €1,300

(b) if the share price at expiration is €52.50, you will exercise the option and the payoff is:

Payoff = 20×100× (€52.50 – €51.50)


Payoff = €2,000

If the share price at expiration is €50.50, you will not exercise the option because the strike price is
higher than the selling price. The payoff is zero.

(c) you could sell the underlying asset (e.g., stock) on or before the expiration date if you own a put
option contract.

For each share, the ask price for the April put option with an exercise price of €51 is €0.50.
Because each contract is for 100 shares, if you buy 10 contracts, the total cost is:

Cost = 10×100 shares per contract×€0.50


Cost = €500

The maximum gain on the put option would occur if the share price dropped to €0.

We also need to subtract the initial cost from your gain, so:
Maximum gain = 10×100×€51– €500
Maximum gain = €50,500

If the share price at expiration is €48, the payoff is:


Payoff = 10×100× (€51 – €48)
Payoff = €3,000

If the share price at expiration is €48, the position will have a net gain of:
Net gain = 10×100× (€51 – €48) – €500
Net gain = €2,500

(d) if you sell option contract, bid/sell price is relevant to your transaction because it is the price at
which you could sell an option. As the seller of the option, you don’t have the flexibility to decide
whether to exercise the option or not, the owner of the option will decide.

For each share, the bid price for the April put option with an exercise price of €51 is €0.47.

Because each contract is for 100 shares, if you sell 10 contracts, you will sell them for:
10 ×100 shares per contract × €0.47 = €470

At a spot price of €48, the put option is in-the-money and it is beneficial for the owner to exercise it.
As the writer, you will suffer loss because you must fulfil your responsibility:

Net loss = –10×100× (€51 – €48) + €470


Net loss = –€2,530

At a spot price of €54 at expiration, the put options will be out-of-the-money and the owner of the put
option should not exercise it. As the writer, you will be left with the gain you made when you initially
sold the put options:

Net gain = 10 × 100 × €0.47 = €470

At break-even, your loss from the put option could offset the initial gain you made when you initially
sold the put options, assume X = break-even share price

€0.47 × 10 × 100 = (€51 – X) × 10 × 100


€470 = €51,000 – 1,000X
1,000X = €50,530
X = €50.53
Q2.

(a) Put-call parity: the payoff of buying a call option and buying a treasury bill is the same as the payoff
of buying a put option and buying the stock.

If you Buy a call option and T-Bills:

For each share, the ask price for the September call option with an exercise price of $33 is $1.08.
The purchase price of T-Bills is $33.

If you sell an eBay stock and a put option:

The selling price for an eBay stock is the bid price = $33.75
For each share, the bid price for the September put option with an exercise price of $33 is $0.24.

The total payoff=–$1.08 – $33 + $33.75+ $0.24 = –$0.09

(b) if you buy an eBay stock and a put option:

The purchase price for an eBay stock is the ask price = $33.76
For each share, the ask price for the September put option with an exercise price of $33 is $0.26.

If you sell a call option and T-Bills:

For each share, the bid price for the September call option with an exercise price of $33 is $1.03.
The selling price of T-Bills is $33.

The total payoff=–$0.26 – $33.76 + $33+ $1.03 = $0.01

(c) In part (a), the total payoff is negative but becomes positive in part (b). The total payoff is nonzero
because of the transaction costs.

Total transaction cost = call spread ($0.05) + put spread ($0.02) + stock spread ($0.01) = $0.08 in total
loss in (a) & (b).
The put-call parity holds only if the put and the call have both the same exercise price and the same
expiration date. The maturity date of the zero-coupon bond (e.g., T-bills in our setting because we
ignore negligible interest) must be the same as the expiration date of the options.

Homework:

Q3.

(a) Put-call parity: the payoff of buying a call option and buying a treasury bill is the same as the payoff
of buying a put option and buying the stock.

If you Buy a call option and T-Bills:

For each share, the ask price for the August call option with an exercise price of $140 is $6.95.
The purchase price of T-Bills is $140.

If you sell an IBM stock and a put option:

The selling price for an IBM stock is the bid price = $146.29
For each share, the bid price for the August put option with an exercise price of $140 is $0.71.

The total payoff=–$6.95 – $140 + $146.29 + $0.71 = $0.05

(b) if you buy an IBM stock and a put option:

The purchase price for an IBM stock is the ask price = $146.35
For each share, the ask price for the August put option with an exercise price of $140 is $0.75.

If you sell a call option and T-Bills:

For each share, the bid price for the August call option with an exercise price of $140 is $6.80.
The selling price of T-Bills is $140.

The total payoff=–$0.75 – $146.35 + $140 + $6.80 = –$0.30

(c) In part (a), the total payoff is positive but becomes negative in part (b) because of the transactions
costs.
Total transaction cost = call spread ($0.15) + put spread ($0.04) + stock spread ($0.06) = $0.25 in total
loss in (a) & (b).

The put-call parity holds only if the put and the call have both the same exercise price and the same
expiration date. The maturity date of the zero-coupon bond (e.g., T-bills in our setting because we
ignore negligible interest) must be the same as the expiration date of the options.

Q4.

Using the put–call parity and solving for the put price, we get:

Price of underlying Price of Price of Present value of


+ = +
equity put call exercise price

S + P = C + Ee − rT
£4.29 + £0.25 = C+ £4.40e–(0.026)(3/12)

C = £0.169

Common questions

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Transaction costs introduce discrepancies between theoretical models and actual market conditions, influencing the accuracy of pricing models based on put-call parity. These costs typically include bid-ask spreads and commission fees, which reduce arbitragists' profits, causing deviations from the expected parity. For example, a total transaction cost of $0.08 altered the payoff, exemplifying how even minimal costs impact theoretical outcomes and real market prices .

The total payoff differs due to the impact of transaction costs, which include the differences in the bid-ask spreads of the options and the underlying asset. Transaction costs effectively reduce the arbitrage profit opportunities. For example, in case (a) the total cost from spreads results in a negative payoff, whereas in case (b) the total cost turns a potential scenario from negative to positive payoff, illustrating that transaction costs can turn what appears to be profitable into a loss or less profitable transaction .

Equality in exercise price and expiration date is key to maintaining put-call parity as these parameters ensure that the intrinsic value components of call and put options can be directly compared. Any mismatch might result in inefficiencies that disrupt the parity, allowing for arbitrage opportunities. Equal terms guarantee that the valuation focuses solely on market sentiment and interest rates, with transaction timing and price synchronization crucial for true parity .

Understanding put-call parity helps in strategic portfolio management by allowing investors to construct synthetic positions, hedge risks, or exploit arbitrage opportunities. This relation provides a foundational rule that ensures fair pricing between options and their underlying securities. Traders can use this knowledge to balance portfolios or optimize the cost-effectiveness of speculative and hedging strategies, factoring in factors such as interest rates and potential mispricings .

The break-even share price is crucial as it defines the price at which the gains from exercising the option balance out the initial costs, meaning there are no net profits or losses. It serves as a benchmark for traders to evaluate when holding or exercising might start yielding a financial advantage. For instance, with a put option, the calculated break-even price of €50.53 represents the threshold where the seller's loss balances the initial gain from option sales .

The maximum gain for a put option occurs when the price of the underlying asset drops to zero since the holder can sell the underlying asset at the strike price, securing a gain of the strike price minus the cost of the put. For instance, if the strike price is €51 and the option cost is €500, the maximum gain would be €50,500 . Conversely, the maximum loss is the premium paid for the option itself, such as the initial cost of €500 for purchasing the option contracts .

Put-call parity demonstrates that the payoff from simultaneously buying a call option and a treasury bill (zero-coupon bond) should equal the payoff from buying a put option and purchasing the underlying stock. This relationship is based on the assumption that the call and put options have the same exercise price and expiration date. For example, if you buy a call option and T-Bills, the total cost represents the future price of owning the stock, equivalent to the payoff from owning the put option and stock, after considering transaction costs .

The exercise price determines whether an option is in-the-money and thus profitable to exercise. For a call option, it is exercised if the market price exceeds the exercise price, allowing the holder to purchase the stock for less than the market value. Conversely, a put option is exercised when the exercise price is higher than the market price, allowing the holder to sell the stock for more than the market value .

The bid-ask spread affects the profitability by determining the transaction costs when entering and exiting an options position. When selling option contracts, the bid price determines how much you receive per contract sold. A larger spread indicates higher transaction costs, reducing net gains from selling the contract. For instance, if you sell put options with a bid price of €0.47, this sell price dictates your initial gain, yet any required settlement if the option is exercised, as well as other costs, contribute to the final net outcome .

Yes, put-call parity can be a risk management tool by providing insights into no-arbitrage conditions and ensuring fair pricing between puts and calls with the same strike price and expiration. By leveraging this relationship, traders can create synthetic positions to hedge against market movements. For example, constructing equivalent positions using calls, puts, and the underlying asset allows traders to lock in profits or mitigate losses under certain market conditions, while also highlighting discrepancies that may indicate mispricing .

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