Acts4130 14F A2qs

THE UNIVERSITY OF IOWA
College of Liberal Arts and Sciences

Department of Statistics and Actuarial Science
ACTS:4130
Quantitative Methods for Actuaries

Assignment 2 (Fall 2014)
Instructor : Ambrose Lo
Grader : Yao Chen
INSTRUCTIONS
1. This assignment covers material in Chapter 2 and consists of 5 questions numbered 1 through
5 for a total of 60 points. The points for each question are indicated at the beginning of the
question.
2. Answer ALL FIVE questions.
3. Remember to write your name and staple your work.
4. Hand in your work at the beginning of class on October 3, 2014 (Friday). Late work will not be
accepted.
5. You are welcome to discuss assignment problems with me during my office hours. You are also
encouraged to discuss homework problems with other students. However, what you hand in
must ultimately be your own work.
** BEGINNING OF ASSIGNMENT 2 **
1. (Practice with put-call parity) (5 points) You are given the following table of call and put
option premiums for various exercise prices:
Exercise price
20
25
K
Call premium
6.25
2.35
3.54
Put premium
3.13
4.03
3.54
All options in the table have the same time to expiration.

Calculate the value of K.
2. (Several option strategies) (22 points) Assume the effective 6-month interest rate is 2%, the
S&R 6-month forward price is $1020, and use these premiums for S&R options with 6 months
to expiration:
Strike ($)
950
1000
1020
1050
1107
Call ($)
120.405
93.809
84.470
71.802
51.873
Put ($)
51.777
74.201
84.470
101.214
137.167
(a) (Derivatives Markets, Exercise 3.11) (8 points) Suppose you invest in the S&R index for
$1,000, buy a 950-strike put, and sell a 1050-strike call.
(i) (5 points) Draw a profit diagram for this position.
(ii) (3 points) If you wanted to construct a zero-cost collar keeping the put strike equal to
$950, in what direction would you have to change the call strike? Explain briefly.
(b) (Derivatives Markets, Exercise 3.14) (5 points) Suppose you buy a 950-strike S&R call,
sell a 1000-strike S&R call, sell a 950-strike S&R put, and buy a 1000-strike S&R put.
Calculate the implicit effective interest rate over 6 months in these cash flows.
(c) (5 points) Suppose you buy a 1050-strike S&R straddle. For what range of the S&R index
will you make a profit?
(d) (Derivatives Markets, Exercise 3.15) (4 points) Construct a profit diagram for the following ratio spread:
Buy two 950-strike calls, sell three 1050-strike calls.
ACTS:4130 (22S:174) Fall 2014
Assignment 2
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3. (13 points) You are given the following information:

The current price to buy one share of ABC stock is 100.
The continuously compounded risk-free rate is 5%.
1-year European options on one share of ABC stock have the following prices:
Strike Price
90
100
110
Call Option Price

14.63
6.80
2.17
Put Option Price

0.24
1.93
6.81
A position consists of buying one share of the stock, buying a 90-strike put, buying a 110-strike
call and selling two 100-strike calls.
(a) (5 points) Draw the profit diagram of this position.
(b) (4 points) Determine the one-year stock price(s) that result(s) in a zero profit.
(c) (2 points) Determine the maximum profit and the corresponding range of one-year stock
price this profit is attained.
(d) (2 points) Determine the maximum loss and the corresponding range of one-year stock
price this loss is incurred.
4. (An unfamiliar option position) (10 points) A research analyst, who has studied a firm for
many years, believes that at the end of two months, the stock price of the firm will be very likely
to stay between $95 and $105, and the chance that the stock price is below $90 or above $110
is negligible. He would like to hold a portfolio of options which gives a constant profit if the
stock price stays between $95 and $105 at the end of two months, and gives a constant loss if
the stock price is below $90 or above $110.
The following 2-month European call options for the stock are available for trading:
Exercise price
90
95
100
105
110
Call premium
10
7
4
2
1
The continuously compounded annual risk-free interest rate is 5%.

(a) (5 points) Calculate the cost of constructing such a portfolio.
(b) (5 points) Draw the payoff and profit diagrams for the portfolio.
ACTS:4130 (22S:174) Fall 2014

Assignment 2
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5. (Applying what you learnt in Case Study 1) (10 points) The payoff of a derivative contract
maturing in one year is given by
3S1 40, if 0 S1 < 10,

Payoff = 4S1 50, if 10 S1 < 20,
S1 + 10, if S1 20,
where S1 is the one-year price of the underlying stock.
You are given:
The continuously compounded annual risk-free interest rate is 5%.
The current stock price is 15.
The price of a 10-strike 1-year call option is 5.52.
The price of a 20-strike 1-year call option is 0.38.
The price of the above derivative is 11.
Describe actions you could take to exploit an arbitrage opportunity, and calculate the present
value of the arbitrage profit. Show your work.
** END OF ASSIGNMENT 2 **
ACTS:4130 (22S:174) Fall 2014

Assignment 2
-4-
STOP
Suggested solutions to ACTS:4130 (22S:174) Assignment 2

1. Solution. By put-call parity (applied to K = 20 and K = 25),
(
6.25 3.13 = PV(F0,T ) PV(20)
,
2.35 4.03 = PV(F0,T ) PV(25)
which gives PV(1) = 0.96 and PV(F0,T ) = 22.32. As C(K) = P(K), K = F0,T = 22.32/0.96 =
23.25 .
2. Solution.
(a) (i) The initial investment of the position is

S0 + P(950) C(1, 050) = 1, 000 + 51.777 71.802 = 979.975,
which grows to 979.975(1.02) = 999.5745 in 6 months.
The payoff diagram (optional) and profit diagram are sketched in Figure 1 below.
Payoff
Profit
1,050
950
50.4255
49.5745
950 1,050
950 1,050
S0.5
Figure 1: Profit diagram for Question 2 (a)(i).

Remark 1. The combined position is a collared stock.
(ii) The initial investment of the long collar is negative. If the put strike is fixed at 950, we
need a less expensive call, which can be achieved by increasing the call strike price.
(b) The four actions described in the question result in a long box spread, in which the initial
investment is
C(950) P(950) C(1, 000) + P(1, 000) = 120.405 51.777 93.809 + 74.201
= 49.02.
At expiration, we receive 1, 000 950 = 50. The implicit 6-month effective interest is
50
1 = 2% .
49.02
ACTS:4130 (22S:174) Fall 2014
Assignment 2 Suggested Solutions
-5-
S0.5
(c) The profit of the long 1,050-strike straddle is

|S0.5 1, 050| (71.802 + 101.214)(1.02) = |S0.5 1, 050| 176.47632,
which is positive if and only if S0.5 < 873.52 or S0.5 > 1, 226.48 .
(d) The initial investment of the ratio spread is
2C(950) 3C(1, 050) = 2(120.405) 3(71.802) = 25.404,
which grows to 25.404(1.02) = 25.91208 in 6 months.
The profit diagram, sketched below, is obtained by translating the payoff diagram (which
you may sketch first) downward by 25.91208.
Profit
e=
op
Sl
Slo
p
e=
174.08792
25.91208
950
1,050
S0.5
3. Solution. (a) The investment required to create the position, which is a 90-100-110 long butterfly spread, is
S0 + P(90) +C(110) 2C(100) = 100 + 0.24 + 2.17 2(6.8) = 88.81,
which grows to 88.81e0.05 = 93.36 in one year.
The profit diagram is sketched below:
ACTS:4130 (22S:174) Fall 2014

-6-
100
Payoff
90
6.64
90
100
S1
110
3.36
Profit
(b) From the profit diagram in part (a), we see that the two stock prices that result in a zero
profit are 93.36 and 106.64 .
(c) The maximum profit is 6.64 , attained when S1 = 100 .
(d) The maximum loss is 3.36 , attained when S1 90 or S1 110 .
4. Solution.
(a) To construct a portfolio with the desired payoff structure, we:

Buy a 90-strike call
Sell a 95-strike call
Buy a 110-strike call
The cost of constructing such a portfolio is

C(90) C(95) C(105) +C(110) = 10 7 2 + 1 = 2 .
(b) The payoff diagram is as follows:
Payoff
ACTS:4130 (22S:174) Fall 2014

90
95
105
-7-
110
S1/6
After subtracting the cost of 2e0.05/6 = 2.0167 from the payoff, we obtain the profit:
Profit
2.9833
90
2.0167
95
105
110
S1/6
5. Solution. By inspection, the payoff of the derivative can be expressed as (you may draw a payoff
diagram if you wish)
Payoff = 3S1 40 + (S1 10)+ 3(S1 20)+ ,
which means that the fair price of the derivative equals
Price = 3S0 40e0.05 +C(10) 3C(20)
= 3(15) 40e0.05 + 5.52 3(0.38)
= 11.33,
which is higher than the observed price by 0.33. To effect an arbitrage, we buy the observed
derivative and sell the synthetic derivative. Specifically, we:
Buy the derivative
Sell 3 units of the stock
Lend 40e0.05
Buy 3 20-strike calls
At time 0, we realize a cash inflow of 11.33 11 = 0.33. At time 1, the payoff is exactly zero
because the synthetic derivative replicates the original derivative. Overall, the present value of
the arbitrage profit is 0.33 .
** END OF SOLUTIONS **
ACTS:4130 (22S:174) Fall 2014
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THE UNIVERSITY OF IOWA

College of Liberal Arts and Sciences

Quantitative Methods for Actuaries

All options in the table have the same time to expiration.

3. (13 points) You are given the following information:

Call Option Price

Put Option Price

The continuously compounded annual risk-free interest rate is 5%.

ACTS:4130 (22S:174) Fall 2014

3S1 40, if 0 S1 < 10,

ACTS:4130 (22S:174) Fall 2014

Suggested solutions to ACTS:4130 (22S:174) Assignment 2

(a) (i) The initial investment of the position is

Figure 1: Profit diagram for Question 2 (a)(i).

(c) The profit of the long 1,050-strike straddle is

ACTS:4130 (22S:174) Fall 2014

(a) To construct a portfolio with the desired payoff structure, we:

The cost of constructing such a portfolio is

ACTS:4130 (22S:174) Fall 2014

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