1. Northrop Grumman made a collared offer for TRW. The terms of the offer are given below.

Northrop Grumman will acquire TRW for $60 per share in common stock

The exact exchange ratio will be determined by dividing $60 by the average of the reported closing s
Northrop Grumman common stock on the New York Stock Exchange for the five consecutive trading d
including the second trading day prior to the closing of the merger. The exchange ratio will not be les
than 0.5357 of a Northrop Grumman share.

a. Replicate the payoff to the TRW shareholders using some combination of puts, calls and Northrop G

Implied
Ratio Price
Max share price: 0.43 $137.99
Min share price: 0.54 $112.00

Share Price of Northrop Ratio in Use

$100.00 0.5357
$105.00 0.5357
$110.00 0.5357 0.5600
$115.00 0.5217 0.5400
$120.00 0.5000 0.5200
$125.00 0.4800 0.5000
$130.00 0.4615 0.4800
$135.00 0.4444 0.4600
$140.00 0.4348
0.4400
$145.00 0.4348
0.4200
$150.00 0.4348
0.4000
$100.00 $110.00 $120.00 $130.00 $
Answer:
Buy 0.5357 shares of Northrop Grumman stock
Long call 0.4348 shares of NG with strike price of $137.99
Sell call of 0.5357 shares of NG with strike price of $112.00

Long Short Long

Share Price position Call Call Net
$100.00 $53.57 $0.00 $0.00 $53.57
$105.00 $56.25 $0.00 $0.00 $56.25
$70.00
$110.00 $58.93 $0.00 $0.00 $58.93
$115.00 $61.61 ($1.61 $0.00 $60.00
$65.00
$120.00 $64.28 ($4.28 $0.00 $60.00
$125.00 $66.96 ($6.96 $0.00 $60.00
$130.00 $69.64 ($9.64 $0.00 $60.00 $60.00

$55.00
 $65.00

$60.00
$135.00 $72.32 ($12.32 $0.00 $60.00
$140.00 $75.00 ($15.00 $0.87 $60.87 $55.00
$145.00 $77.68 ($17.68 $3.05 $63.05
$150.00 $80.36 ($20.36 $5.22 $65.22 $50.00
$100.00 $110

b. If the value of the synthetic position exceeded the value of TRW shares, what position could you ta
associated with your strategy?

Answer: Sell the synthetic position and buy TRW shares. The arbitrage opportunity likely
executed. If the deal is not executed, the value of the TRW shares may drop.

2. Consider the following prices for coffee options which were taken from WSJ. The units are dollars pe

Strike Price July Calls July Puts

$1.60 0.1125 0.1635
$1.65 0.1000 0.2000
$1.70 0.0900 0.2410
$1.75 0.0760 0.2770

The futures price for July delivery is $1.549/lb.

a. Suppose I am a coffee producer (i.e I sell coffee). Assume my break‐even price for coffee is $1.55/lb

i. If I want to lock in a selling price for coffee, what futures position should I take? What profit have I lo
Answer: Take a long futures position at $1.55 to offset your naturally short position. You
$0 profit.
ii. I would like to protect myself against drops in the July price of coffee but still benefit if the July price
take if I want a $1.65/lb. floor on my selling price? What is the lowest "all‐in" price (i.e. the net cost or
from the coffee) that I will receive for the coffee. Draw the profit diagram with and without the floor.
hedged position start to do better than the unhedged position?
Answer: Buy a put with a strike price of $1.65. The lowest all-in price will be $1.45. At an
do better than the unhedged.
Payoff at Expiration
Cost of Hedged
Coffee Price Coffee Put Payoff Put Profit
$1.25 $0.40 $1.65 -0.2000 $1.45
$1.30 $0.35 $1.65 -0.2000 $1.45
$1.35 $0.30 $1.65 -0.2000 $1.45
$1.40 $0.25 $1.65 -0.2000 $1.45
$1.45 $0.20 $1.65 -0.2000 $1.45
$1.50 $0.15 $1.65 -0.2000 $1.45
$1.55 $0.10 $1.65 -0.2000 $1.45
$1.60 $0.05 $1.65 -0.2000 $1.45
$1.65 $0.00 $1.65 -0.2000 $1.45
$1.70 $0.00 $1.70 -0.2000 $1.50
$1.75 $0.00 $1.75 -0.2000 $1.55
$1.80 $0.00 $1.80 -0.2000 $1.60

$2.00
$1.90
$1.80 Hedged Profit
$1.70 Unhedged
$1.60 Profit
$1.50
$1.40
$1.30
$1.20
$1.10
$1.00
$1.20 $1.30 $1.40 $1.50 $1.60 $1.70 $1.80

ii. How would I get a collar with a $1.60 floor and a $1.70 cap? Draw the profit diagram for the collar.
collar start to do better than the unhedged position?
Answer: Buy a put with a strike price of $1.60 and sell a call with a strike of $1.70. The he
price is below $1.57.
Payoff at Expiration

Coffee Price Put Call Payoff Cost of Put Cost of Call

$1.25 $0.40 $0.00 $1.65 -0.1635 0.0900
$1.30 $0.35 $0.00 $1.65 -0.1635 0.0900
 $1.35 $0.30 $0.00 $1.65 -0.1635 0.0900
$1.40 $0.25 $0.00 $1.65 -0.1635 0.0900
$1.45 $0.20 $0.00 $1.65 -0.1635 0.0900
$1.50 $0.15 $0.00 $1.65 -0.1635 0.0900
$1.55 $0.10 $0.00 $1.65 -0.1635 0.0900
$1.60 $0.05 $0.00 $1.65 -0.1635 0.0900
$1.65 $0.00 $0.00 $1.65 -0.1635 0.0900
$1.70 $0.00 ($0.00 $1.70 -0.1635 0.0900
$1.75 $0.00 ($0.05 $1.70 -0.1635 0.0900
$1.80 $0.00 ($0.10 $1.70 -0.1635 0.0900
$1.85 $0.00 ($0.15 $1.70 -0.1635 0.0900
$1.90 $0.00 ($0.20 $1.70 -0.1635 0.0900
$1.95 $0.00 ($0.25 $1.70 -0.1635 0.0900
$2.00 $0.00 ($0.30 $1.70 -0.1635 0.0900
$2.05 $0.00 ($0.35 $1.70 -0.1635 0.0900

$2.00

$1.80 Hedged Profit

Unhedged
$1.60 Profit

$1.40

$1.20

$1.00
$1.20 $1.40 $1.60 $1.80 $2.00

b. Suppose I am a Starbucks (i.e., I buy coffee). Assume my break‐even price for coffee is $1.70/lb.
i. If I want to lock in a buying price for coffee, what futures position should I take? What profit
have I locked in?
Answer: Take a short futures position at $1.55 to offset your naturally long position. You

ii. I would like to protect myself against increases in the July price of coffee but still benefit if the July p
position should I take if I want a $1.70/lb. cap on my coffee costs? What is the highest "all‐in" price th
Answer: Buy a call with a strike price of $1.70. The highest all-in price will be $1.79. At an
to do better than the unhedged.
Payoff at Expiration
Cost of Hedged
Coffee Price Coffee Call Payout Call Payout
$1.50 $0.00 ($1.50 -0.0900 ($1.59
$1.55 $0.00 ($1.55 -0.0900 ($1.64
$1.60 $0.00 ($1.60 -0.0900 ($1.69
$1.65 $0.00 ($1.65 -0.0900 ($1.74
 $1.70 $0.00 ($1.70 -0.0900 ($1.79
$1.75 $0.05 ($1.70 -0.0900 ($1.79
$1.80 $0.10 ($1.70 -0.0900 ($1.79
$1.85 $0.15 ($1.70 -0.0900 ($1.79
$1.90 $0.20 ($1.70 -0.0900 ($1.79
$1.95 $0.25 ($1.70 -0.0900 ($1.79
$2.00 $0.30 ($1.70 -0.0900 ($1.79
$2.05 $0.35 ($1.70 -0.0900 ($1.79

ii. How would I get a collar with a $1.60 floor and a $1.65 cap?
Answer: Sell a put with a strike of $1.60 and buy a call with a strike of $1.65.

Payout at Expiration

Coffee Price Put Call Payout Cost of Put Cost of Call

$1.25 ($0.35 $0.00 ($1.60 0.1635 -0.1000
$1.30 ($0.30 $0.00 ($1.60 0.1635 -0.1000
$1.35 ($0.25 $0.00 ($1.60 0.1635 -0.1000
$1.40 ($0.20 $0.00 ($1.60 0.1635 -0.1000
$1.45 ($0.15 $0.00 ($1.60 0.1635 -0.1000
$1.50 ($0.10 $0.00 ($1.60 0.1635 -0.1000
$1.55 ($0.05 $0.00 ($1.60 0.1635 -0.1000
$1.60 $0.00 $0.00 ($1.60 0.1635 -0.1000
$1.65 $0.00 $0.00 ($1.65 0.1635 -0.1000
$1.70 $0.00 $0.05 ($1.65 0.1635 -0.1000
$1.75 $0.00 $0.10 ($1.65 0.1635 -0.1000
$1.80 $0.00 $0.15 ($1.65 0.1635 -0.1000
$1.85 $0.00 $0.20 ($1.65 0.1635 -0.1000
$1.90 $0.00 $0.25 ($1.65 0.1635 -0.1000
$1.95 $0.00 $0.30 ($1.65 0.1635 -0.1000
$2.00 $0.00 $0.35 ($1.65 0.1635 -0.1000
$2.05 $0.00 $0.40 ($1.65 0.1635 -0.1000

($1.00

($1.20
Hedged Payout
Unhedged
($1.40
Payout
($1.60

($1.80

($2.00

$1.20 $1.40 $1.60 $1.80 $2.00

($1.80

($2.00

$1.20 $1.40 $1.60 $1.80 $2.00

er are given below.

ge of the reported closing sale prices per share of

e five consecutive trading days ending on and
xchange ratio will not be less than 0.4348 or more

of puts, calls and Northrop Grumman stock.

0 $120.00 $130.00 $140.00 $150.00

$70.00

$65.00

$60.00

$55.00
 $65.00

$60.00

$55.00

$50.00
$100.00 $110.00 $120.00 $130.00 $140.00 $150.00

, what position could you take to take advantage of this. What is the risk

itrage opportunity likely represents the risk that the deal is not
s may drop.

WSJ. The units are dollars per pound of coffee.

en price for coffee is $1.55/lb.

I take? What profit have I locked in?

rally short position. You have locked in a breakeven price and therefore
 t still benefit if the July price of coffee rises. What option position should I
in" price (i.e. the net cost or revenue from the option plus the revenue
with and without the floor. At what July spot price for coffee does the

price will be $1.45. At any price below $1.45, the hedged position starts to

Unhedged
Profit
$1.25
$1.30
$1.35
$1.40
$1.45
$1.50
$1.55
$1.60
$1.65
$1.70
$1.75
$1.80

ged Profit
edged
t

rofit diagram for the collar. At what July spot price for coffee does the

a strike of $1.70. The hedged position will do better when the

Hedged Unhedge
Profit d Profit
$1.58 $1.25
$1.58 $1.30
 $1.58 $1.35
$1.58 $1.40
$1.58 $1.45
$1.58 $1.50
$1.58 $1.55
$1.58 $1.60
$1.58 $1.65
$1.63 $1.70
$1.63 $1.75
$1.63 $1.80
$1.63 $1.85
$1.63 $1.90
$1.63 $1.95
$1.63 $2.00
$1.63 $2.05

dged Profit
hedged
ofit

ice for coffee is $1.70/lb.

I take? What profit

urally long position. You have locked in a a profit of $0.15 / lb.

e but still benefit if the July price of coffee drops. What option
the highest "all‐in" price that I will pay for the coffee?
price will be $1.79. At any price above $1.79, the hedged position starts

Unhedged
Payout
($1.50
($1.55
($1.60
($1.65
 ($1.70
($1.75
($1.80
($1.85
($1.90
($1.95
($2.00
($2.05

ke of $1.65.

Hedged Unhedge
Payout d Payout
($1.54 ($1.25
($1.54 ($1.30
($1.54 ($1.35
($1.54 ($1.40
($1.54 ($1.45
($1.54 ($1.50
($1.54 ($1.55
($1.54 ($1.60
($1.59 ($1.65
($1.59 ($1.70
($1.59 ($1.75
($1.59 ($1.80
($1.59 ($1.85
($1.59 ($1.90
($1.59 ($1.95
($1.59 ($2.00
($1.59 ($2.05

ged Payout
edged
ut
3. Suppose that you work for Google and you have accumulated 1,000 shares of Google sto
own any other assets and you are worried about possible adverse changes in the value of y
because your portfolio is so ill‐diversified. You would like to hold on to the stock but you wo
to hedge your position.

a. Using the option pricing spreadsheet available in Derivative Markets, compute

$400 floor on your position which expires in one year. For the inputs, use the follo

Stock Price $406.30

Exercise Price $400.00 Cost / $400 Put
Volatility 29.00% Number:
Risk-free interest rate 4.69% Total Cost
Time to Expiration (years) 1
Dividend Yield 0.00%
# Binomial steps 4
Type (0=Eur, 1=Amer) 1

b. What is the cost of a three year $400 floor?

Stock Price $406.30 Cost / Put

Exercise Price $400.00 Number:
Volatility 29.00% Total Cost
Risk-free interest rate 4.69%
Time to Expiration (years) 3
Dividend Yield 0.00%
# Binomial steps 4
Type (0=Eur, 1=Amer) 1

c. Construct a three year zero‐cost collar with a $360 floor.

Step One: Determine cost of a put option with a $360 Strike

Stock Price $406.30

Exercise Price $360.00 Cost / Put
Volatility 29.00%
Risk-free interest rate 4.69%
Time to Expiration (years) 3
Dividend Yield 0.00%
# Binomial steps 4
Type (0=Eur, 1=Amer) 1

Step Two: Determine strike price of put with identical option premium of $131.40

Stock Price $406.30

 Exercise Price $654.29 Cost / Call
Volatility 29.00%
Risk-free interest rate 4.69%
Time to Expiration (years) 3
Dividend Yield 0.00%
# Binomial steps 4
Type (0=Eur, 1=Amer) 1

3-year zero cost collar is to:

Buy 1,000 $360 strike put options
Sell 1,000 $654.29 strike call options

4. Suppose that Jeff Immelt has been granted a call option on one million shares of GE stock
option will expire in five years and has a strike price equal to $15/share. The option cannot
early and they are not transferable. The price of GE stock is currently $16/share and the fiv
Treasury bond yield is 1.5%.

note: for this problem, I utilized the Black-Scholes European pricing model.

a. If the volatility of GE stock is 35% and the dividend yield is 2.9%, what is the v
Immelt stock options?
Inputs

Stock Price $16.00 Cost / EUR Call Option

Exercise Price $15.00
Volatility 35.00% Number of Options
Risk-free interest rate 1.49%
Time to Expiration (years) 5 Total Value
Dividend Yield 2.90%
# Binomial steps 4
Type (0=Eur, 1=Amer) 0

b. Suppose that as a result of the purchase of another firm, the volatility of GE in

what is the value of the stock options? What does this imply about a manager’s in
undertake risky projects?

Stock Price $16.00 Cost / EUR Call Option

Exercise Price $15.00
Volatility 45.00% Number of Options
Risk-free interest rate 1.50%
Time to Expiration (years) 5 Total Value
Dividend Yield 2.90%
# Binomial steps 4
Type (0=Eur, 1=Amer) 0

This implies that executives are incentivized to increase the risk / volatility of the
earnings as this will increase volatility and the underlying value of the executives
c. Does increasing the dividend yield increase or decrease the value of the option

Increasing a stock's dividend decreases the value of call options and increases th
put options. This is due to the effect of the dividend on the underlying stock pric
issuing a dividend causes a decrease the price of underlying stock.
d 1,000 shares of Google stock. You don’t
rse changes in the value of your portfolio
d on to the stock but you would also like

Derivative Markets, compute the cost of a

r. For the inputs, use the following data:

Cost / $400 Put $36.03

1000
Total Cost $36,035

Cost / Put $56.00

1000
Total Cost $55,995

Cost / Put $39.24

l option premium of $131.40 (using goal seek)

Cost / Call $39.24

one million shares of GE stock. The

15/share. The option cannot be exercised
rrently $16/share and the five‐year

cing model.

d yield is 2.9%, what is the value of Mr

Cost / EUR Call Option $4.18

Number of Options 1,000,000

Total Value ###

er firm, the volatility of GE increases to 45%,

is imply about a manager’s incentive to

Cost / EUR Call Option $5.30

Number of Options 1,000,000

Total Value ###

ase the risk / volatility of the companies

lying value of the executives options.
rease the value of the options? Why?

call options and increases the value of

on the underlying stock price, as
derlying stock.