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Q1.
Consider an option on a non-dividend-paying stock when the stock price is $30, the exercise
price is $29, the risk-free interest rate is 5% per annum, the volatility is 25% 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 putcall parity holds.
In this case S0 30 , K 29 , r 005 , 025 and T 4 12
d1
In this case S0 095 , K 095 , r 005 , rf 004 , 008 and T 075 . The option can be
valued using equation (16.8)
ln(095 095) (005 004 00064 2) 075
d1
01429
008 075
Q3.
The USD/euro exchange rate is 1.3000. The exchange rate volatility is 15%. A US company will
have to pay 1 million euros in three months. The euro and USD risk-free rates are 5% and 4%,
respectively. The company decides to use a range forward contract with the lower strike equal to
1.2500.
(a) What should the higher strike be to create a zero-cost contract?
(b) What position in calls and puts should the company take?
(c) Show that your answer to (a) does not depend on interest rates providing the interest rate
differential between the two currencies, r rf , remains the same.
(a) A put with a strike price of 1.25 is worth $0.019. By trial and error DerivaGem can be
used to show that the strike price of a call that leads to a call having a price of $0.019 is
1.3477. This is the higher strike price to create a zero cost contract.
(b) The company should sell a put with strike price 1.25 and buy a call with strike price
1.3477. This ensures that the exchange rate it receives for the euros is between 1.2500
and 1.3477.
(c) This can be verified using DerivaGem. We can also prove that it is true. If the interest
rate differential remains the same the forward rate remains the same. Equations (16.13)
and (16.14) show that a change in the domestic risk-free rate affects the prices of calls
and puts by the same percentage amount. Hence if 1.25 is the lower strike, 1.3477 will
always be the upper strike.
Q4.
Calculate the implied volatility of soybean futures prices from the following information
concerning a European put on soybean futures:
Current futures price
525
Exercise price
525
Risk-free rate
6% per annum
Time to maturity
5 months
Put price
20
(Hint: by trial and error, or using a program with solver function.)
In this case F0 525 , K 525 , r 006 , T 04167 . We wish to find the value of for which
p 20 where:
p Ke rT N (d2 ) F0e rT N (d1 )
This must be done by trial and error. When 02 , p 2636 . When 015 , p 1978 .
When 0155 , p 2044 . When 0152 , p 2004 . These calculations show that the
implied volatility is approximately 15.2% per annum.
Q5.
Calculate the price of a six-month European put option on the spot value of the S&P 500. The
six-month forward price of the index is 1,400, the strike price is 1,450, the risk-free rate is 5%,
and the volatility of the index is 15%.
The price of the option is the same as the price of a European put option on the forward price of
the index where the forward contract has a maturity of six months. It is given by equation (17.10)
with F0 1400 , K 1450 , r 005 , 015 , and T 05 . It is 86.35.
Q6.
A financial institution has the following portfolio of over-the-counter options on sterling:
Type
Call
Call
Put
Call
Position
1,000
500
2,000
500
Delta of Option
0.5
0.8
-0.40
0.70
Gamma of Option
2.2
0.6
1.3
1.8
Vega of Option
1.8
0.2
0.7
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?
The delta of the portfolio is
1 000 050 500 080 2 000 (040) 500 070 450
The gamma of the portfolio is
1 000 22 500 06 2 000 13 500 18 6 000
The vega of the portfolio is
1 000 18 500 02 2 000 07 500 14 4 000
(a) A long position in 4,000 traded options will give a gamma-neutral portfolio since the long
position has a gamma of 4 000 15 6 000 . The delta of the whole portfolio (including
Q7.
A companys stock is selling for $4. The company has no outstanding debt. Analysts consider the
liquidation value of the company to be at least $300,000 and there are 100,000 shares
outstanding. What volatility smile would you expect to see?
In liquidation the companys stock price must be at least 300,000/100,000 = $3. The companys
stock price should therefore always be at least $3. This means that the stock price distribution
that has a thinner left tail and fatter right tail than the lognormal distribution. An upward sloping
volatility smile can be expected.
Q8.
Consider a European call and a European put with the same strike price and time to maturity.
Show that they change in value by the same amount when the volatility increases from a level,
1 , to a new level, 2 within a short period of time. (Hint Use putcall parity.)
Define c1 and p1 as the values of the call and the put when the volatility is 1 . Define c2 and
p2 as the values of the call and the put when the volatility is 2 . From putcall parity
p1 S0e qT c1 Ke rT
p2 S0e qT c2 Ke rT
If follows that
p1 p2 c1 c2
Q9.
What is the relationship between a regular call option, a binary call option, and a gap call
option?
With the notation in the text, a regular call option with strike price K2 plus a binary call option
that pays off K2 K1 is a gap call option that pays off ST K1 when ST > K2.
Q10.
What is the value in dollars of a derivative that pays off $10,000 in one year provided that the
dollarsterling exchange rate is greater than 1.5000 at that time? The current exchange rate is
1.4800. The dollar and sterling interest rates are 4% and 8% per annum respectively. The
volatility of the exchange rate is 12% per annum.
It is instructive to consider two different ways of valuing this instrument. From the perspective of
a sterling investor it is a cash or nothing put. The variables are S0 1 148 06757 ,
K 1 150 06667 , r 008 , q 004 , 012 , and T 1 . The derivative pays off if the
exchange rate is less than 0.6667. The value of the derivative is 10 000 N (d2 )e0081 where