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Models and Pricing of Financial Derivatives

Homework 1 Deadline: October, 6, 2024

1. Explain carefully the difference between selling a call option and buying a put option.

2. The current price of a stock is $94, and 3-month European call option with a strike price of
$95 currently sell for $4.70. An investor who feels that the price of the stock will increase is trying
to decide between buying 100 shares and buying 2, 000 call options (= 20 contracts). Both strategies
involve an investment of $9, 400. What advice would you give? How high does the stock price have
to rise for the option strategy to be more profitable?

3. A trader buys a European call option and sells a European put option. The options have
the same underlying asset, strike price, and maturity. Describe the trader’s position. Under what
circumstances does the price of the call equal the price of the put?

4. The price of a stock is $40. The price of a 1-year European put option on the stock with a
strike price of $30 is quoted as $7 and the price of a 1-year European call option on the stock with a
strike price of $50 is quoted as $5. Suppose that an investor buys 100 shares, shorts 100 call options,
and buys 100 put options. Draw a diagram illustrating how the investor’s profit or loss varies with
the stock price over the next year. How does your answer change if the investor buys 100 shares,
shorts 200 call options, and buys 200 put options?

5. What is a lower bound for the price of a 1-month European put option on a non-dividend-
paying stock when the stock price is $12, the strike price is $15, and the risk-free interest rate is 6%
per annum?

1
2

6. “The early exercise of an American put is a trade-off between the time value of money and the
insurance value of a put.” Explain this statement.

7. The price of a non-dividend-paying stock is $19 and the price of a 3-month European call
option on the stock with a strike price of $20 is $1. The risk-free rate is 4% per annum. What is
the price of a 3-month European put option with a strike price of $20?

8. A 1-month European put option on a non-dividend-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% per annum. What
opportunities are there for an arbitrageur?

9. (i) The price of an American call on a non-dividend-paying stock is $4. The stock price is
$31, the strike price is $30, and the expiration date is in 3 months. The risk-free interest rate is 8%.
Derive upper and lower bounds for the price of an American put on the same stock with the same
strike price and expiration date.

(ii) Explain carefully the arbitrage opportunities in Problem 9(i) if the American put price is
greater than the calculated upper bound.

10. (i) Suppose that c1 , c2 , and c3 are the prices of European call options with strike prices K1 ,
K2 , and K3 , respectively, where K3 > K2 > K1 and K3 − K2 = K2 − K1 . All options have the same
maturity. Show that
c2 ≤ 0.5(c1 + c3 )
(Hint: Consider a portfolio that is long one option with strike price K1 , long one option with strike
price K3 , and short two options with strike price K2 .)

(ii) What is the result corresponding to that in Problem 10(i) For European put options?

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