SOLVED PROBLEMS SOLVED EXERCISES ON OPTIONS – PROFESSOR GUSTAVO SANTOS

OPTIONS MARKET:

1. An investor purchases a European PUT option on a stock for $3.00, the stock price is $42.00,
and the strike price is $40.00.

a) Under what circumstances does the investor make a profit? Under the scenario where the
stock price falls below $40.

b) Under what circumstances will the option be exercised? When the stock at expiration is below
$37 = $40 – $3

c) Draw a diagram showing the variation of the investor's utility with the price of the stock at the
expiration of the option.

P.Y.G.
R
\
X
\
----------•N—---------------•
X=40 st
-3

2. Suppose a European call option is purchased to buy an Option at $50.00 with a cost of $2.50
and is held until expiration.

a) Under what circumstances does the investor holding the option make a profit? Under the
scenario in which the share price is above $50.

b) Under what circumstances will the option be exercised? When the stock at expiration is above
$52.50= $50 +$2.50
c) Draw a diagram showing the variation of the investor's utility with the price of the stock at the
expiration of the option.

3. Draw a diagram that shows the variation of the investor's utility with the price of the stock at the
expiration of the option for the portfolios listed below. In each one, assume that the exercise price
is equal to the current price of the stock:

a) 1 share and a short position in a call option:

c) 1 share and a short position in two call options:

P.Y.G.

d) 1 share and a short position in four call options:

P.Y.G.

4. Explain why an American option is always worth at least what a European option costs on the
same asset with the same exercise price and exercise date.

Because the American option is exercised at any moment in time, from the moment of its
subscription and given that if it is assumed that it is exercised at the same time as a European
option on the same asset and exercise price, its value must be the same. The additional cost is due
to the possibility of offering the right to exercise early.

5. Explain the difference between writing a call option and buying a put option
When you sell a call option (subscribe a call option) you have an OBLIGATION to sell the asset to
the counterparty, while when you buy the put option you obtain the RIGHT to sell the asset but
not the obligation to do so.

6. The treasurer of a corporation is trying to select between options and forward contracts to
hedge the company's currency risk. Discuss the advantages and disadvantages of each.

Forwards Advantages:
· Hedging mechanism through which the treasurer obtains a fixed exchange rate in the future.
· The Treasurer is immune from adverse movements in the exchange rate.
· It does not require liquidity to carry out coverage.
· It allows planning future cash flows to the extent that the amount of money to be received or
paid is known with certainty.
· Flexibility in compliance, since the treasurer, with prior agreement with the Bank, can make it
DF or NDF.
· It can be combined attractively with other instruments on the market.

Forwards Disadvantages

· The authorization of the counterparty is required to exit the position held before expiration.
· Credit risk is present. (breach)
· It does not allow any choice in the future, it must be fulfilled.
· It is not negotiable.
· There is no secondary market for forwards.

Options Advantages

. A right is exercised if at the time of expiration it is favorable to the treasurer that it can be of
maximum utility
. Can be negotiated – Secondary Market
. Works as unilateral insurance for the Treasurer
. It is leveraged and has limited risk

Options Disadvantages:

. Premium cost could be high

. Liquidity
. Complexity in accounting and valuation

7. Assume that the SPOT GBP and forward rates are as follows:

SPOT 1.6090
FWD 90 DAYS 1.6000 FWD 180 DAYS 1.5910

What opportunities are open to an investor in the following situations: a) Buying a 180-day
European option to buy £1 at $1.560 cost $0.0250

Sell the 180-day FWD for 1.5910, at expiration: sell 1.5910 and exercise the option at 1.560,
generate a profit of:

(1.5910-1.560)= 0.0310-0.0250 =USD$0.0060 per £

b) Buying a European put option to sell £1 at $1.6210 cost $0.0200 for 90 days.

Buy the 90-day FWD for 1.6000, at expiration: buy 1.6000 and exercise the put option at 1.6210,
generate a profit of:

(1.6210-1.6000)= 0.0210-0.0200 =USD$0.0010 per £

8. Assume a call options trade to purchase 500 shares with a strike price of $40 and expiration in 4
months. Explain how the terms of the contract change when: a) The stock has a 10% stock dividend
A 10% dividend is equivalent to a Split of 11 by 10 (11 shares for every 10) with which the exercise
price is reduced to 10/11 of the initial price, which is $36.36 and the number of shares to be
traded will increase by 11 /10 this is 550 shares.
b) The stock has a 10% dividend in cash
The stock falls by the value of the ex-cash dividend, so the strike price is reduced by that amount.
c) Split 4-1 (4 for 1)
A 4 for 1 Split (4 shares for every 1) with which the exercise price is reduced to 1/4 of the initial
price, this is $10.00, and the number of shares to be traded will increase by 4/1, this is 2000
shares.

MARGIN ACCOUNTS:

When shares are purchased, an investor can pay cash or use margin accounts. The initial margin is
usually 50% of the value of the shares and the maintenance on margin is usually 25% of the value of
the shares. When CALL or PUT options are purchased, the premium must be paid in full, that is, the
premium price is not leveraged.

9. An investor buys 500 shares of a firm and sells 5 call option contracts on the firm. The strike
price is $30. The price of the option is $3. What is the minimum cash invested if the share price is
$28?

Buys : 500 shares at $28 = $14000

Margin account 50% =$ 7.000

Sell (receive) 5 contracts at $3= $3*500 = $1.500

°Each contract is 100 shares

The minimum cash required will be:

$14.000-$7.000-$1500 = $5.500

10. What is the lower limit of the price of a six-month call option on a stock that does not pay
dividends, when the stock price is $80, the strike price is $75, and the risk-free rate is 10% per year?

The lower price of a call option is determined by:

S - Xe~ rT
With which the price of the call will be:
80 - 75e-0 1-0.5 = 8. 66
11. What is the lower limit of the price of a two-month put option on a stock that does not pay
dividends, when the stock price is $58, the strike price is $65, and the risk-free rate is 5% per year?

The lower price of a put option is determined by:

Xe-T-S
With which the price of the put will be:
65e-0.05*1/6 - 58 = 6.46

12. A four-month European call option on a dividend-paying stock is currently selling for $5.00.
The share price is $64 and the exercise price is $60, the dividend is expected in one month in the
amount of $0.80, the risk-free rate is estimated at 12% for all maturities. Is there an arbitration
opportunity?

The bottom price of a call option on a dividend-paying stock is determined by:

c > s - D - Xe~ rT

Therefore, the call price must be greater than:

64 - 0. 8Oe-0 12*1/12 _ 6Oe -o 12*1/3 _ 5 56

Since the option is sold at $5.00, there is the possibility of arbitrage:

1. Buy the option

2. Short the Stock, the dividend is paid
3. Invest the Cash at 12%
Result:
From 2 and 1 you get: $64 -$0.7920- $5= $78.20 which are invested at 12% for four months. As a
result we have the following:

78. 20e0 12*1/3 - 8i 39

At the end of the fourth month, when the option expires if the option price is greater than $60,
the option is exercised and we obtain:

$81.39 – $60.00= $21.39

If it is less than $60, let's assume $59, the share is bought in the market and the short position is
closed, so the profit would be:

$81.39 – 59.00= $22.39

13. A one-month put option on a non-dividend-paying option is sold for $2.50. The share price is
$47, the strike price is $50, and the risk-free rate is 6% per year. Is there a possibility of arbitration?

The lower price of a put option on a stock that does not pay dividends is determined by:

p > Xe~ rT - S
Therefore, the put price must be greater than:

50e-0.0611/12 - 47 = 2. 75

Since the option is sold at $2.50, there is the possibility of arbitrage:

1. Borrow $49.50
2. Buy the stock at $47
3. Buy the put option at $2.50
Result:
At the end of the month you must pay what you borrowed

49. 50e0.06*1/12 = 49 75

At the end of the month, when the option expires if the option price is greater than $50, assume
$52, you sell the stock and pay off the loan:

$52.00 – $49.75= $2.25

If it is less than $50, you exercise the option to sell at $50 and obtain a profit of:

$50.00 – $49.75= $0.25

14. The price of a European call option which expires in 6 months and has a strike price of $30 is
$2.00. The price of the underlying asset is $29 and a dividend of $0.50 is expected in two months
and in 5 months. The term interest rate structure is flat, with all risk-free rates at 10%. What is the
price of a European put option that expires in six months and has an exercise price of $30.

You have the following:

Call Option: Put Option:

X = $30 X = $30

T = 0.5 years T = 0.5 years

c = $2.00

S = $29

r = 10%

With which the PUT-CALL parity can be used given that they have the same expiration and the
same exercise price, therefore to derive the price of the Put option:

PUT-CALL parity with dividends:

c + D + Xe~ rT = p + S

The value of the dividends is:

D = 0. 50e0 1*2/12 + o. 50e0 1*5/12 = o. 97
Replacing:
p = $2 + $0. 97 + $30e0 1-0 5 - $29 = 2. 51

15. The price of an American call option on a non-dividend paying option is $4.00. The share price
is $31.00 and the strike price is $30, the expiration date is in 3 months. The risk-free rate is 8%.
Calculate the upper and lower band for the price of an American put option on the same stock,
same strike price and expiration.

Under the assumption of parity in American options, the lowest value of the premium of an
American Put option is reached from the inequality:

CP <S-Xe~ rT

With which
P > C -S + Xe~ rT
Replacing
P > $4 - $31 + 30e-0.08-0.25 = 2.40

Similarly, the maximum value that the American Put option can take is given by:

CP> SX

P<CS+X
Replacing
P < $4- $31 + 30 = 3.00

16. Suppose you are the Manager and sole owner of a highly leveraged company. All of the
company's debt will mature in one year. If at that time, the value of the company is greater than the
face value of the debt, you make the payment of the debt. If the value of the company is less than
the face value of the debt, you declare bankruptcy and the creditors take over your company.

Express your position as an option on the value of the company.

I am with a long CALL position, given that if the value of the company is below the face level of
the debt in one year, the company is sold to the suppliers, its worst loss is limited to the debt,
otherwise it is not sold and The debt is paid, its value may be high and the signature is still
maintained.

17. Suppose two put options on a stock with strike price of $30 and $35 and premium of $4 and $7
respectively are in the market. How can you use options to create:

a) A Bull Spread . Build a table showing the profit and its Payoff

It can be created by buying the Put option with a strike price of $30 and selling a Put with a strike
price of $35.
 ACTION RANGE PAYOFF PAYOFF TOTAL UTILITY
LONG PUT SHORT PUT PAYOFF

S T > 35 0 0 0 $3
30 < S T < 35 0 S T — 35 S T - 35 Sr-32
S T < 30 30 -S T S T - 35 -5 -2

b) A Bear Spread. Build a table showing the profit and its Payoff

It can be created by buying the Put option with strike price $35 and selling a Put with strike price
$30

ACTION RANGE PAYOFF PAYOFF TOTAL UTILITY

LONG PUT SHORT PUT PAYOFF

S T > 35 0 0 0 -$3
30 < S T < 35 35 -S T 0 35 -S T 32-Sy
S T < 30 35 -S T — 30 5 2

18) Three put options on a stock have the same expiration date and their exercise prices are $55,
$60 and $65, the option premiums are $3, $5 and $8 respectively. Explain how a Butterfly spread
can be created. Construct a table showing the usefulness of the strategy. In what ranges of the
stock price could the Butterfly spread leave a loss?

It can be created as follows:

1. Buy a put with exercise $55

2. Buy a put with exercise $65
3. Sell two Puts with exercise $60
The total cost is: $3+$8-(2*$5)=$1, which is the maximum loss.

If the share price is less than 55 or greater than 65, you lose $1

Between $55 and $65 a profit is obtained, where the maximum profit is $4 and is achieved with a
share price of $60

19.A Diagonal spread is created by buying a Call with strike price X 2 with expiration date T 2 and selling a Call with a strike
price of Make a diagram that shows the usefulness when:
a) X2 > X1
b) X 2 < X 1

20. A Call option with a strike price of $60 costs $6.00. A Put with the same strike price and
expiration costs $4.00. Build a table showing the usefulness of the Straddle. For what price ranges
does the Straddle leave profit or loss.

The maximum cost is $10.

Range
0 - 50 Utility
50-70 Loss
>70 Utility

21. Make a diagram that shows the variation of the profit and loss of an investor with terminal
value of the share price – assume that the strike price is equivalent to the current price of the
share – of a portfolio that consists of:
a)A stock and a short position in a call option

b) Two stocks and a short position in a call option

c) One stock and two short positions in a call option

22.The current price of a stock is $50. Assume that the stock's expected return is 18% per year and
its volatility is 30% per year. What is the probability distribution of the stock price in 2 years?
Calculate the mean and standard deviation of the distribution. Determine a 95% Confidence
Interval.

The prices have a lognormal distribution, which means:

(o2N—
lnSi~O InS +(u--)T, avT
\Z)

So:

InSt~0 In 50 + 0.18 - 2, 0. 32

In St. 094,0.4242]

A 95% confidence interval for a normally distributed variable has a value of 1.96 times the
standard deviation around the mean, then

8. 094 - 1. 96 * 0.4242 < InS < 8. 094 + 1. 96 * 0.4242

7.2625 < InS < 8.9254

g7.2625 < S< g8.9254

The action will be in two years, between: (1425.81; 7520.59)

23. What is the price of a European call option on a stock that does not pay dividends, when the
share price is $52, the exercise price is $50, the risk-free rate 12% per year, volatility of 30% per
year and Is the expiration time three months?

Using the Black & Sholes model we have:

c = SN^) - Xe~ rT N(d2)

Where _In(x)+(r+02/2)T
and _In(x)+(ro2/2)T
1 o/t and

Then you have:

In (52) + (0.12 + 0. 32/2)0. 25

say = —M0--------------- ----------------------= 0. 5364
0. 3V0. 25
 ln
(56) + (°- 12 - °- 32/2)o. 25
d2 =------------- 1 -----= 0. 3864
0.3/0.25

N(0. 5364) = 0. 7041

NO. 3864) = 0. 6504

c = 52 * 0. 5364 - 50e-0 12*0.250. 3864 = $9 143