Review Problems

Mechanics of Option Markets (8)

1. Suppose that a European call option to buy a share for $50.00 costs $2.50 and is
held until maturity. Under what circumstances will the holder of the option make a
profit? Under what circumstances will the option be exercised? Draw a diagram
illustrating how the profit from a long position in the option depends on the stock price at
maturity of the option.

2. Suppose that a European put option to sell a share for $60.00 costs $4 and is held
until maturity. Under what circumstances will the seller of the option (the party with the
short position) make a profit? Under what circumstances will the option be exercised?
Draw a diagram illustrating how the profit from a short position in the option depends on
the stock price at maturity of the option.

3. Draw a diagram showing the variation of an investor’s profit or loss with the
terminal stock price for a portfolio consisting of

a. One share and a short position in one call option

b. Two shares and a short position in one call option
c. One share and a short position in two call options
d. One share and a short position in four call options

In each case, assume that the call option has a strike price equal to the current stock
price. Also assume the contract multiplier is one.

4. Explain why an American option is always worth at least as much as a European

option on the same asset with the same strike price and exercise date.

5. Explain why an American option is always worth at least as much as its intrinsic
value.

6. Explain carefully the difference between writing a call option and buying a put
option.

7. Consider an exchange-traded call option contract to buy 500 shares with a strike
price of $40 and maturity in four months. Explain how the terms of the option contract
change when there is

a. A 10 percent stock dividend

b. A 10 percent cash dividend
c. A 4-for-1 stock split

8. An investor writes five naked call option contracts. The option price is $3.50, the
strike price is $60.00, and the stock price is $57.00. What is the initial margin
requirement?

1
 Properties of Stock Options (9)
1. What is a lower bound for the price of a six-month call option on a nondividend-
paying stock when the stock price is $80, the strike price is $75, and the risk-free interest
rate is 10 percent per annum?

2. What is a lower bound for the price of a two-month European put option on a
nondividend-paying stock when the stock price is $58, the strike price is $65, and the
risk-free interest rate is 5 percent per annum?

3. 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 percent per annum for all
maturities. What opportunities are there for an arbitrageur?

4. A one-month European put option on a nondividend-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 percent per annum. What opportunities are there for an arbitrageur?

5. The price of a European call that expires in six months and has a strike price of
$30 is $2.00. 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 percent. What is the price of a European put option that expires in
six months and has a strike price of $30?

6. The price of an American call on a nondividend-paying stock is $4. The stock

price is $31, the strike price is $30, and the expiration date is in three months. The risk-
free interest rate is 8 percent. Derive upper and lower bounds for the price of an
American put on the same stock with the same strike price and expiration date.

Trading Strategies Involving Options (10)

1. Use put-call parity to relate the initial investment for a bull spread using calls to
the initial investment for a bull spread using puts.

2. Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $7,
respectively. How can the options be used to create (a) a bull spread and (b) a bear
spread? Construct a table that shows the profit and payoff for both spreads.

3. Three put options on a stock have the same expiration date and strike prices of
$55, $60, and $65. The market prices are $3, $5, and $8, respectively. Explain how a
butterfly spread can be created. Construct a table showing the profit from the strategy.
For what range of stock prices would the butterfly spread lead to a loss?

4. Use put-call parity to show that the cost of a butterfly spread created from
European puts is identical to the cost of a butterfly spread created from European calls.

2
5. A call with a strike price of $60 costs $6. A put with the same strike price and
expiration date costs $4. Construct a table that shows the profit from a straddle. For
what range of stock prices would the straddle lead to a loss?

6. An investor believes that there will be a big jump in a stock price but is uncertain
as to the direction. Identify six different strategies the investor can follow and explain
the differences among them.

7. What is the result if the strike price of the put is higher than the strike price of the
call in a strangle?

Introduction to Binomial Trees (11)

1. A stock price is currently $50. It is known that at the end of two months it will
be either $53 or $48. The risk-free interest rate is 10 percent per annum with continuous
compounding. What is the value of a two-month European call option with a strike price
of $49? Use no-arbitrage arguments.

2. A stock price is currently $80. It is known that at the end of four months it will
be either $75 or $85. The risk-free interest rate is 5 percent per annum with continuous
compounding. What is the value of a four-month European put option with a strike price
of $80? Use no-arbitrage arguments.

3. A stock price is currently $50. It is known that at the end of six months it will be
either $60 or $42. The risk-free rate of interest with continuous compounding is 12
percent per annum. Calculate the value of a six-month European call option on the stock
with an exercise price of $48. Verify that no-arbitrage and risk-neutral valuation
arguments give the same answers.

4. A stock price is currently $40. It is known that at the end of three months it will
be either $45 or $35. The risk-free rate of interest with quarterly compounding is 8
percent per annum. Calculate the value of a three-month European put option on the
stock with an exercise price of $40. Verify that no-arbitrage and risk-neutral valuation
arguments give the same answers.

5. A stock price is currently $50. Over each of the next two three-month periods it
is expected to go up by 6 percent or down by 5 percent. The risk-free interest rate is 5
percent per annum with continuous compounding. What is the value of a six-month
European call option with a strike price of $51?

6. For the situation considered in 5 above, what is the value of a six-month

European put option with a strike price of $51? Verify that the European call and
European put prices satisfy put-call parity. If the put option were American, would it
ever be optimal to exercise it early at any of the nodes on the tree?

3
7. A stock price is currently $40. Over each of the next two three-month periods it
is expected to go up by 10 percent or down by 10 percent. The risk-free interest rate is
12 percent per annum with continuous compounding.
a. What is the value of a six-month European put option with a strike price of $42?
b. What is the value of a six-month American put option with a strike price of $42?

8. A stock price is currently $25. It is known that at the end of two months it will
be either $23 or $27. The risk-free interest rate is 10 percent per annum with continuous
compounding. Suppose ST is the stock price at the end of two months. What is the value
of a derivative that pays ST2 at this time?

Valuing Stock Options: The Black-Scholes Model (12)

1. A stock price is currently $50. Assume that the expected return from the stock is
18 percent per annum and its volatility is 30 percent per annum. What is the probability
distribution for the stock price in two years? Calculate the mean and standard deviation
of the distribution. Determine 95 percent confidence intervals.

2. A stock price is currently $40. Assume that the expected return from the stock is
15 percent and its volatility is 25 percent. What is the probability distribution for the rate
of return (with continuous compounding) earned over a one-year period?

3. A stock price has an expected return of 16 percent and a volatility of 35 percent.

The current price is $38.

a. What is the probability that a European call option on the stock with an exercise
price of $40 and a maturity date in six months will be exercised?
b. What is the probability that a European put option on the stock with the same
exercise price and maturity will be exercised?

4. Suppose that observations on a stock price (in dollars) at the end of each of 15
consecutive weeks are as follows:

30.25, 32, 31.125, 30.125, 30.25, 30.375, 30.625, 33,

32.875, 33, 33.50, 33.50, 33.75, 33.50, 33.25

Estimate the stock price volatility. What is the standard error of your estimate?

5. What is the price of a European call option on a nondividend-paying stock when

the stock price is $52, the strike price is $50, the risk-free interest rate is 12 percent per
annum, the volatility is 30 percent per annum, and the time to maturity is three months?

6. What is the price of a European put option on a nondividend-paying stock when

the stock price is $69, the strike price is $70, the risk-free interest rate is 5 percent per
annum, the volatility is 35 percent per annum, and the time to maturity is six months?

4
7. Consider an option on a nondividend-paying stock when the stock price is $30,
the exercise price is $29, the risk-free interest rate is 5 percent per annum, the volatility is
25 percent per annum, and the time to maturity is four months.

a. What is the price of the option if it is a European call?

b. What is the price of the option if it is an American call?
c. What is the price of the option if it is a European put?
d. Verify that put-call parity holds.

Options on Stock Indices and Currencies (13)

1. Consider a stock index currently standing at 250. The dividend yield on the index
is 4 percent per annum and the risk-free rate is 6 percent per annum. A three-month
European call option on the index with a strike price of 245 is currently worth $10.
What is the value of a three-month put option on the index with a strike price of 245?

2. The S&P index currently stands at 348 and has a volatility of 30 percent per
annum. The risk-free rate of interest is 7 percent per annum and the index provides a
dividend yield of 4 percent per annum. Calculate the value of a three-month European
put with an exercise price of 350.

3. Suppose that the spot price of the Canadian dollar is U.S. $0.75 and that the
Canadian dollar/U.S. dollar exchange rate has a volatility of 4 percent per annum. The
risk-free rates of interest in Canada and the United States are 9 percent and 7 percent per
annum, respectively. Calculate the value of a European call option with an exercise price
of $0.75 and an exercise date in nine months.

4. A stock index currently stands at 300. It is expected to increase or decrease by 10

percent over each of the next two time periods of three months. The risk-free interest
rate is 8 percent and the dividend yield on the index is 3 percent. What is the value of a
six-month put option on the index with a strike price of 300 if it is (a) European and (b)
American?

5. Would you expect the volatility of a stock index to be greater or less than the
volatility of a typical stock? Explain you answer.

6. A mutual fund announces that the salaries of its fund managers will depend on the
performance of the fund. If the fund loses money, the salaries will be zero. If the fund
makes a profit, the salaries will be proportional to the profit. Describe the salary of a
fund manager as an option. How is a fund manager motivated to behave with this type of
remuneration package?

7. Suppose that a portfolio is worth $60 million and the S&P 500 is at 300. If the
value of the portfolio mirrors the value of the index, what options should be purchased to
provide protection against the value of the portfolio falling below $54 million in one
year’s time?

5
 Futures Options (14)
1. Suppose you buy a put option contract on October gold futures with a strike price
of $400 per ounce. Each contract is for the delivery of 100 ounces. What happens if you
exercise when the October futures price is $380?

2. Suppose you sell a call option contract on April live-cattle futures with a strike
price of 70 cents per pound. Each contract is for the delivery of 40,000 pounds. What
happens if the contract is exercised when the futures price is 75 cents?

3. Consider a two-month call futures option with a strike price of 40 when the risk-
free interest rate is 10 percent per annum. The current futures price is 47. What is a
lower bound for the value of the futures option if it is (a) European and (b) American?

4. A futures price is currently 40. It is known that at the end of three months the
price will be either 35 or 45. What is the value of a three-month European call option on
the futures with a strike price or 42 if the risk-free interest rate is 7 percent per annum?

5. A futures price is currently 60. It is known that over each of the next two three-
month periods it will either rise by 10 percent or fall by 10 percent. The risk-free interest
rate is 8 percent per annum. What is the value of a six-month European call option on
the futures with a strike price of 60? If the call were American, would it ever be worth
exercising it early?

6. A futures price is currently 25, its volatility is 30 percent per annum, and the risk-
free interest rate is 10 percent per annum. What is the value of a nine-month European
call on the futures with a strike price of 26?

7. A futures price is currently 70, its volatility is 20 percent per annum, and the risk-
free interest rate is 6 percent per annum. What is the value of a five-month European put
on the futures with a strike price of 65?

8. “The price of an at-the-money European call futures option always equals the
price of a similar at-the-money European put futures option.” Explain why this
statement is true.

The Greek Letters (15)

1. A deposit instrument offered by a bank guarantees that investors will receive a
return during a six-month period that is the greater of (a) zero and (b) 40 percent of the
return provided by a market index. An investor is planning to put $100,000 in the
instrument. Describe the payoff as an option on the index. Assuming that the risk-free
rate of interest is 8 percent per annum, the dividend yield on the index is 3 percent per
annum, and the volatility of the index is 25 percent per annum, is the product a good deal
for the investor?

6
2. Suppose that a stock price is currently $20 and that a call option with an exercise
price of $25 is created synthetically using a continually changing position in the stock.
Consider the following two scenarios:
a. Stock price increases steadily from $20 to $35 during the life of the option.
b. Stock price oscillates wildly, ending up at $35.
Which scenario would make the synthetically created option more expensive? Explain
your answer.

3. What is the delta of a short position in 1,000 European call options on silver
futures? The options mature in eight months, and the futures contract underlying the
option matures in nine months. The current nine-month futures price is $8 per ounce, the
exercise price of the options is $8, the risk-free interest rate is 12 percent per annum, and
the volatility of silver is 18 percent per annum.

4. A company uses delta hedging to hedge a portfolio of long positions in put and
call options on a currency. Which of the following would give the most favorable
results?
a. A virtually constant spot rate
b. Wild movements in the spot rate
Explain your answer.

5. A financial institution has the following portfolio of over-the-counter options on

sterling:
Option Option Option
Type Position Delta Gamma Vega

Call -1,000 0.50 2.2 1.8

Call -500 0.80 0.6 0.2
Put -2,000 -0.40 1.3 0.7
Call -500 0.70 1.8 1.4

A traded option is available with a delta of 0.6, a gamma of 1.5 and a vega of 0.8.
a. What position in the traded option and in sterling would make the portfolio both
gamma neutral and delta neutral?
b. What position in the traded option and in sterling would make the portfolio both
vega neutral and delta neutral?

6. Consider again the situation in Problem 5 above. Suppose that a second traded
option with a delta of 0.1, a gamma of 0.5 and a vega of 0.6 is available. How could the
portfolio be made delta, gamma, and vega neutral?