Derivatives

Fall, 2016

Chapter 9
1. Suppose that you buy a e1,000,000 call option against dollars with a strike price of
$1.2750/e. Describe this option as the right to sell a specific amount of dollars for
euros at a particular exchange rate of euros per dollar. Why is this latter option a
dollar put option against the euro?
The e1,000,000 call option against dollars with a strike price of $1.2750/e gives
the buyer the right, but not the obligation, to buy e1,000,000 at the strike price of
$1.2750/e in the following case
xT > 1.2750
where xT is the future spot price of euro. If this is true, then the person would pay
$1,275,000 for the 1,000,000 euros. The transaction is giving up $1,275,000 in order
to receive the 1,000,000 euros.
This latter option is a $1,275,000 dollar put option against euros with a strike price
of e0.784314/$. Why?
xT > 1.2750

1
1
<
= 0.7843
xT
1.2750

But 1/xT is the price of one dollar in terms of euro. This condition says you then give
up $1,275,000 in order to receive the 1,000,000 euros. Or, sell $1,275,000 in order to
receive the 1,000,000 euros, when the above condition is true. Clearly, this is the same
as an option to sell $1,275,000 at a strike price of [1 / ($1.2750/e)] = e0.784314/$.
2. Property of option prices.
(a) A call with a low strike price is at least as valuable as an otherwise identical call
with higher strike price C(K1 ) C(K2 )
Proof: Take the bull spread buy a low-strike and sell a high-strike calls. The
worst case is you dont exercise either. Then the profit/loss is C (K2 ) C (K1 ),
and this has to be negative to rule out arbitrage.
(b) With different strike prices (K1 < K2 < K3 ), the premium difference between
otherwise identical calls with different strike prices cannot be greater than the
difference in strike prices C(K1 ) C(K2 ) K2 K1
Proof: Take the bear spread buy a high-strike and sell a low-strike calls. The
worst case is you exercise both. Then the profit/loss is (S K2 ) (S K1 )
C (K2 ) + C (K1 ), and this has to be negative to rule out arbitrage.
(c) Premiums decline at a decreasing rate for calls with progressively higher strike
prices. (Convexity of option price with respect to strike price)
C(K1 ) C(K2 )
C(K2 ) C(K3 )

K2 K1
K3 K2
Assume that K2 =

K1 +K3
,
2

which implies that (K3 K2 = K2 K1 ).

Derivatives

Fall, 2016

Take a butterfly buy a low-strike and a high-strike, then sell two medium-strike
calls. The payoff of such strategy is positive (actually, non-negative) everywhere.
Thus, its price today have to be positive. Thus, it must be true that:
[C(K1 ) C(K2 )] [C(K2 ) C(K3 )] 0
We can divide both sides above and get
C(K1 ) C(K2 ) C(K2 ) C(K3 )

0
K2 K1
K3 K2
or equivalently
C(K1 ) C(K2 )
C(K2 ) C(K3 )

K2 K1
K3 K2