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CFA

Q&A
14-06-2015

Ex pp59: A 1-year call option on Cross Reef Inc. with


an exercise price of $60 is trading for $8.The current
stock price is $62. The risk-free rate is 4%. Calculate
the price of the synthetic put option implied by put-call
parity.

C0 +

X / (1+r) t

] = P0 + S 0

Fiduciary call

Protective put

According to put-call parity, the price of the synthetic


put option is:
Synthetic put: p = c S + [x/(1+r)t]
= 8 - 62 + [60/
(1+.04)]
= $ 3.69

Example: pp59/60: Exploiting violations of put-call parity


The stock of ArbCity Inc. is trading for $75. A 3-month call option with an exercise price
of $75 is selling for $4.50, and a 3-month put at $75 is selling for $3.80. The risk-free
rate is 5%. Calculate the no-arbitrage price of the put option, and illustrate how the
violation of put-call parity can be exploited to earn arbitrage profits.

First, calculate what the put option should be selling for, given the other
prices:

P = c S + [x/(1+r)t] = 4.50-75+[75/(1.05)0.25] = $3.59


Put-call parity doesnt hold because the actual market price of the put is
$3.80, not the no-arbitrage price of $3.59:
c + [x/(1+r)t]

P+S ,

4.50+74.09 3.80+75

78.59

78.80
The fiduciary call (the left side of the equation) is relatively underpriced,
and the
protective put (the right side) is relatively overpriced.
Therefore, the arbitrage strategy is to buy the fiduciary call (and pay
$78.59) and short-sell the protective put (and receive $78.80). T
The arbitrage profits from this trade are $78.80 $78.59, or $0.21 per
share.
The net cash flow at maturity will be zero, so weve produced cash flow of
$0.21 today with no cash outflow obligation in the futurethats what we
call an arbitrage profit.

One period Binomial Model


Share of stock current price = $30
Size of possible price change & probability of these
change
U = Size of up move = 1.333 (33.3%)
D = size of down move = 1/U = 1/1.333 = 0.75
25%)

= probability of up-move = 0.55

= probability of down move= 1-


0.45
D

(-

= 1-0.55=

The one-period binomial tree for the stock is shown


as

One period Binomial Model


$30
Today
One Year

$30x1.333=$4
0.0
$30x0.7500=$
22.5

The probabilities of an up-move and a downmove are calculated based on the size of the
moves and the risk-free rate as:

u = risk-neutral probability of an up-move=

1+ Rf

D/ U D

D = risk -neutral probability of a down-move =


D

P62 Example: Calculating call option value with a one-period binomial


tree

Use the binomial tree in Figure 3 to calculate the value today


of a one-period call option on the stock with an exercise price
of $30. Assume the risk-free rate is 7%, the current value of
the stock is $30, and the size of an up-move is 1.333.

D = size of downward move =1/U = 1/1.333 = 0.75

u = risk-neutral probability of an up move


= 1 + 0.07 0.75 / 1.333 0.75 = 0.55

= risk neutral probability of adown move


= 1 0.55 = 0.45

Next, determine the payoffs to the option in each state. If the stock
moves
up to $40, a call option with an exercise price of $30 will pay off $10.
If the stock moves down to $22.50, the call option will be worthless.
The option payoffs are illustrated in the following figure.

Let the stock values for the up-move and down-move be S1+ and S1 and for the call values, c1 + and c1One period call option with X= $30

u=
0.55
D=
0.45
Today
One Year

The expected value of the option in one period is:


E(call option value in 1 year) = ($10 0.55) + ($0
0.45) = $5.50
The value of option today, discounted at Rf of 7%
C0 = $5.50 /1.07 = $5.14

P63:Example:
Valuing a one-period put option on a stock
Use the information in the previous two examples to calculate the
value of a put option on the stock with an exercise price of $30.

If the stock moves up to $40, a put option with an exercise


price of
$30 will be worthless. If the stock moves down to $22.50, the
put
option will be worth $7.50.
The risk-neutral probabilities are 0.55 and 0.45 for an up- and
down-move, respectively. The expected value of the put option
in
one period is:
E(put option value in 1 year) = ($0 0.55) + ($7.50 0.45) =
$3.375
The value of the option today, discounted at the risk-free rate
of
7%, is:
P0 = $3.375/ 1.07 = $ 3.154

Arbitrage with a One-Period Binomial Model


Example P64: Calculating arbitrage profit

Assume the option in the previous example is actually selling for


$6.50. Illustrate how this arbitrage opportunity can be exploited
to earn an arbitrage profit. Assume we trade 100 call options.
Answer
Because the option is overpriced, we will short 100 options and
purchase a certain number of shares of stock determined by the
hedge ratio:
Delta = $10-$0/$40-$22.5 =0.5714 shares
per option
total shares of stock to purchase
=1000.5714 =57.14
A portfolio that is long 57.14 shares of stock at $30 per share
and
short 100 calls at $6.50 per call has a net cost of:
net portfolio cost = (57.14 $30) (100 $6.50) =
$1,064

Arbitrage with a One-Period Binomial Model


Example P64: Calculating arbitrage profit

The values of this portfolio at maturity if the stock


moves up to $40
or down to $22.50 are:
portfolio value in up-move
= (57.14 $40) (100 $10) = $1,286
portfolio value in down-move
= (57.14 $22.50) (100 $0) = $1,286
The return on the portfolio in either state is:
Portfolio return = $1286 / $1064 - 1 = 0.209
=20.9%

Arbitrage with a One-Period Binomial Model


Example P64: Calculating arbitrage profit

This is a true arbitrage opportunity! Weve created


a portfolio that
earns a return of 20.9% no matter what happens
next period.
That means its risk free. The actual risk-free rate in
the market is
7%. The profitable arbitrage trades are to:
Borrow $1,064 at 7% for one year. In one year, well owe
$1,064 1.07 = $1,138.48.
Buy the hedged portfolio for $1,064.
In one year, collect the $1,286, repay the loan at
$1,138.48, and keep the arbitrage profits of $147.52.

Calculating delta
Delta, the change in the price of an option for a
one-unit
change in the price of the underlying security:
Delta

call = C1 C0 / S1 S0 = C / S
C = change in the price of the call over a short time interval
S = change in the price of the underlying stock over a short time
interval

Example: Calculating delta


During the last ten minutes of trading, call options on Commart
Inc.
common stock have risen from $1.20 to $1.60. Shares of the
underlying stock have risen from $51.30 to $52.05 during the
same
time interval. Calculate the delta of the call option
Delta call = $1.60 - $1.20 /$52.05 - $51.30 = 0.40/0.75
=0.533

1. C ompare the call and put prices on a stock


that doesnt pay a dividend (NODIV) with
comparable call and put prices on another
stock (DIV) that is the same in all respects
except it pays a dividend. Which of the
following statements is most accurate? Price of:

A. DIV call will be less than price


of NODIV call.
B. NODIV call will equal price of NODIV
put.
C. NODIV put will be greater than price
of DIV put.

2. I n a one-period binomial model, the


hedge ratio is 0.35. To construct a riskless
arbitrage involving 1,000 call options if the
option is overpriced, what is the
appropriate portfolio?

Calls
A. Buy 1,000 options
shares
B. Buy 1,000 options
2,857 shares
C. Sell 1,000 options
350 shares

Stock
Short 350
Short
Buy

3. Which of the following statements is least


accurate? The value of a:

A. call option will decrease as


the risk-free rate increases.
B. put option will decrease as the
exercise price decreases.
C. call option will decrease as the
underlying stock price decreases

7. A synthetic European put option is created


by:

A. buying the discount bond, buying


the call option, and short-selling the
stock.
B. buying the call option, short-selling the
discount bond, and short-selling the stock.
C. short-selling the stock, buying the
discount bond, and selling the call option.

SWAP
1. T he current U.S. dollar ($) to Canadian dollar (C$)
exchange rate is 0.7. In a $1 million plain vanilla
currency swap, the party that is entering the swap to
hedge existing exposure to a C$-denominated fixedrate liability will:

A. receive $1 million at the


termination of the swap.
B. pay a fixed rate based on the yield
curve in the United States.
C. receive a fixed rate based on
the yield curve in Canada.

2. A European-style payer swaption gives its


holder the:

A. right to enter a swap by paying the


strike price at expiration of the option.
B. right to enter a swap at expiration
of the option as the fixed-rate payer.
C. option to take either side of a swap at
a certain date in the future, by making a
current payment.

3. At what point in a swaps life is the credit


risk in an interest rate swap the greatest?

A. In the middle.
B. At the end, when the largest
payments are due.
C. At the beginning, because all the
payments remain.

4. C onsider a 6-year plain vanilla currency swap in which


we will receive LIBOR semiannually and pay 9% fixed
semiannually in British pounds ( ). The notional value
of the swap is 50 million. The current spot rate is
$1.50 per . Which of the following transactions would
replicate the payoffs to the pay-fixed side of the swap?

Bond to issue
purchase
A. 9% fixed, 50 million
million
B. 9% fixed, 50 million
million
C. LIBOR, 112 million
million

Bond to
LIBOR, $33
LIBOR, $75
9% fixed, $33

11. The equity return receiver in an equity


return-for-fixed-rate equity swap receives
payments that are equivalent to which of the
following strategies?
A. Buy and hold the index stocks and issue a
fixed-rate bond.
B. I ssue a bond, short the index stocks, and
adjust the short position value to the principal
amount at each payment date.
C. Buy the index stocks, adjust the portfolio
value to the notional amount of the swap at
each payment date, and issue a fixed-rate
bond.