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Solution To Problem 9

The document contains summaries of several problems related to options pricing and trading strategies. It provides diagrams illustrating how an investor's profit varies with the underlying stock price for different option positions, including long and short positions in puts and calls. Key details are given for how an option's terms change due to corporate actions like stock splits or dividends. The problems demonstrate how an options portfolio can construct different profit/loss profiles depending on the number of contracts held.

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Ong Ming Kai
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216 views5 pages

Solution To Problem 9

The document contains summaries of several problems related to options pricing and trading strategies. It provides diagrams illustrating how an investor's profit varies with the underlying stock price for different option positions, including long and short positions in puts and calls. Key details are given for how an option's terms change due to corporate actions like stock splits or dividends. The problems demonstrate how an options portfolio can construct different profit/loss profiles depending on the number of contracts held.

Uploaded by

Ong Ming Kai
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Problem 9.1.

An investor buys a European put on a share for $3. The stock price is $42 and the strike price is $40.
Under what circumstances does the investor make a profit? Under what circumstances will the option
be exercised? Draw a diagram showing the variation of the investors profit with the stock price at the
maturity
of
the
option.
The investor makes a profit if the price of the stock on the expiration date is less than $37. In these
circumstances the gain from exercising the option is greater than $3. The option will be exercised if
the stock price is less than $40 at the maturity of the option. The variation of the investors profit with
the
stock
price
in
Figure
S9.1.

6
4

Profit ($)

2
0
30 32 34 36 38 40 42 44 46 48 50
-2
-4

Stock Price ($)

Figure S9.1

Investors profit in Problem 9.1

Problem 9.2.
An investor sells a European call on a share for $4. The stock price is $47 and the strike price is $50.
Under what circumstances does the investor make a profit? Under what circumstances will the option
be exercised? Draw a diagram showing the variation of the investors profit with the stock price at the
maturity
of
the
option.
The investor makes a profit if the price of the stock is below $54 on the expiration date. If the stock
price is below $50, the option will not be exercised, and the investor makes a profit of $4. If the stock
price is between $50 and $54, the option is exercised and the investor makes a profit between $0
and $4. The variation of the investors profit with the stock price is as shown in Figure S9.2.

6
4
2

Profit ($)

0
-240 42 44 46 48 50 52 54 56 58 60
-4
-6
-8

Stock Price ($)


Figure S9.2 Investors profit in Problem 9.2
Problem 9.9.
Suppose that a European call option to buy a share for $100.00 costs $5.00 and is held until
maturity. Under what circumstances will the holder of the option make a profit? Under what
circumstances will the option be exercised? Draw a diagram illustrating how the profit from a long
position in the option depends on the stock price at maturity of the option.
Ignoring the time value of money, the holder of the option will make a profit if the stock price at
maturity of the option is greater than $105. This is because the payoff to the holder of the option is, in
these circumstances, greater than the $5 paid for the option. The option will be exercised if the stock
price at maturity is greater than $100. Note that if the stock price is between $100 and $105 the
option is exercised, but the holder of the option takes a loss overall. The profit from a long position is
as shown in Figure S9.3.

Figure S9.3 Profit from long position in Problem 9.9


Problem 9.12.
A trader buys a call option with a strike price of $45 and a put option with a strike price of $40. Both
options have the same maturity. The call costs $3 and the put costs $4. Draw a diagram showing the

variation

of

the

traders

profit

with

the

asset

price.

Figure S9.6 shows the variation of the traders position with the asset price. We can divide the
alternative asset prices into three ranges:

a) When the asset price less than $40, the put option provides a payoff of 40 ST and the
call option provides no payoff. The options cost $7 and so the total profit is 33 ST .

b) When the asset price is between $40 and $45, neither option provides a payoff. There is a
net loss of $7.
c) When the asset price greater than $45, the call option provides a payoff of ST 45 and
the put option provides no payoff. Taking into account the $7 cost of the options, the total
profit is ST 52 .

The trader makes a profit (ignoring the time value of money) if the stock price is less than $33 or
greater than $52. This type of trading strategy is known as a strangle and is discussed in Chapter 11.

Figure S9.6

Profit from trading strategy in Problem 9.12

Problem 9.13.
Explain why an American option is always worth at least as much as a European option on the same
asset
with
the
same
strike
price
and
exercise
date.
The holder of an American option has all the same rights as the holder of a European option and more.
It must therefore be worth at least as much. If it were not, an arbitrageur could short the European
option and take a long position in the American option.
Problem 9.14.
Explain why an American option is always worth at least as much as its intrinsic value.
The holder of an American option has the right to exercise it immediately. The American option must
therefore be worth at least as much as its intrinsic value. If it were not an arbitrageur could lock in a
sure profit by buying the option and exercising it immediately.
Problem 9.17.
Consider an exchange-traded call option contract to buy 500 shares with a strike price of $40 and
maturity in four months. Explain how the terms of the option contract change when there is

a) A 10% stock dividend

b) A 10% cash dividend


c) A 4-for-1 stock split
a) The option contract becomes one to buy 500 11 550 shares with an exercise price
40 1.1 3636 .
b) There is no effect. The terms of an options contract are not normally adjusted for cash
dividends.
c) The option contract becomes one to buy 500 4 2 000 shares with an exercise price of

40 4 $10 .

Problem 9.23.
The price of a stock is $40. The price of a one-year European put option on the stock with a strike
price of $30 is quoted as $7 and the price of a one-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 investors 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?
Figure S9.7 shows the way in which the investors profit varies with the stock price in the first case.
For stock prices less than $30 there is a loss of $1,200. As the stock price increases from $30 to
$50 the profit increases from $1,200 to $800. Above $50 the profit is $800. Students may express
surprise that a call which is $10 out of the money is less expensive than a put which is $10 out of the
money. This could be because of dividends or the crashophobia phenomenon discussed in Chapter
19.
Figure S9.8 shows the way in which the profit varies with stock price in the second case. In this case
the profit pattern has a zigzag shape. The problem illustrates how many different patterns can be
obtained by including calls, puts, and the underlying asset in a portfolio.

Figure S9.7

Profit in first case considered Problem 9.23

Figure S9.8

Profit for the second case considered Problem 9.23

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