FINS2624

PROBLEM SET 9 SOLUTIONS

Question 1.

a)

To generate the iron butterfly using only call and put options, we do the following:
- Long 1 put with strike price of $45
- Short 1 put with strike price of $50
- Long 1 call with strike price of $55
- Short 1 call with strike price of $50

b)

To generate the iron butterfly using only call options and bonds, we do the following:
- Long 1 call with strike price of $45
- Long 1 call with strike price of $55
- Short 2 calls with strike price of $50
- Short 1 bond with face value of $5

c)

The cost of setting up the iron butterfly is the net cash flow we received at time 0:
1.876 + 3.73 4.013 + 6.168 = $4

The profit/loss at time T is the approximately payoff of the iron butterfly + $4.

So, we shift up the payoff diagram by $4 to obtain the profit diagram.

Note: Technically speaking, the profit/loss at time T is payoff of the iron butterfly + $4er,
where $4er is the time T future value of $4 we obtained at time 0; r is the appropriate
interest rate to be found in (e).

d)

We hope that $46 < ST < $54, such that we have profit
e)

We know that the same iron butterfly can be constructed by method (a) or (b). And from (c),
we know that the net cash flow we received at time 0 is $4. Hence, by a no arbitrage
argument,

$4 = $9.07 $4.013 + 2 $6.168 + $5

Solving for r, we get:

4.752
= ln 0.05
5

f)

By put-call parity, we know that

0 = 0 + 0

where the call and the put options have the same strike price $X.

Using the call and put with strike price $X = $45 (for example),

0 = $9.070 + $45 0.03 $1.876 = $50

Question 2

[a]
The call option is at the money, so S0 = X = 50.
From put-call parity:
X 50
C =P + S0 =4 + 50 =$5.18
(1 + rf )T
1.10.25

[b]
Since you believe that the stock price will stay in a narrow range of $50, you should bet against
volatility and form a strategy resulting in positive payoffs within that range.

We learnt from the lecture that a Butterfly spread strategy will have that kind of payoff, but it
involves only call options.

A general principal of option investments is: when you buy options (i.e., hold long options), you
bet on volatility (upside price movement for call options, and downside price movement for put
options). For example, a Straddle strategy (one long call + one long put) bets on both sides of
price movement.

So if you are betting against volatility, you should take the opposite sell options. Now lets
look at the strategy of selling a straddle, i.e., a short call plus a short put. Doing so will give you
at time 0 premium income of:

$5.18 + $4 = $9.18

And its payoff at time T will be:

Short Straddle
$

X=50

ST

-50
Hence, the strategy will give you a maximum profit of $9.18 when the stock ends up at $50.
And your profit will decrease when the stock price move away from $50 in either direction
because you have to pay the option buyer in that case. The stock price can move by $9.18 in
either direction before your profits become negative.

[c] &[d]
From put-call parity:
St ct = PV(X) pt
And thus
St = PV(X) pt + ct
So to replicate a stock, you would need to: buy a call, sell (write) a put, and buy a (zero-
coupon) bond (i.e. make a lending). The strike prices of both options and the face value of the
bond should be the same (X), and lets take X = 50.
We can check whether such strategy indeed replicates a stock:
The payoff is as follows:
Position Value at time 0 CF in 3 months
ST X ST > X
Call (long) C = 6.18 0 S T 50
Put (short) P = 4.00 (50 S T) 0
50
Bond (Long) = 48.82 50 50
1.101 / 4
50
Total CP+ = 50.00 ST ST
1.101 / 4

Under no arbitrage condition, the stock price should equal to the cost of its replicating strategy,
i.e., the call premium, minus the put premium, and plus the bond price (the present value of its
face value):

St = PV(X) pt + ct = 50/(1.10^1/4) 4 + 6.18 = $51.

Solutions to selected end-of-chapter questions
BKM Chapter 20

1. Options provide numerous opportunities to modify the risk profile of a portfolio.

The simplest example of an option strategy that increases risk is investing in an all
options portfolio of at the money options (as illustrated in the text). The leverage
provided by options makes this strategy very risky, and potentially very profitable.
An example of a risk-reducing options strategy is a protective put strategy. Here, the
investor buys a put on an existing stock or portfolio, with exercise price of the put
near or somewhat less than the market value of the underlying asset. This strategy
protects the value of the portfolio because the minimum value of the stock-plus-put
strategy is the exercise price of the put.

2. Buying a put option on an existing portfolio provides portfolio insurance, which is

protection against a decline in the value of the portfolio. In the event of a decline in
value, the minimum value of the put-plus-stock strategy is the exercise price of the
put. As with any insurance purchased to protect the value of an asset, the trade-off
an investor faces is the cost of the put versus the protection against a decline in
value. The cost of the protection is the cost of acquiring the protective put, which
reduces the profit that results should the portfolio increase in value.

3. An investor who writes a call on an existing portfolio takes a covered call position.
If, at expiration, the value of the portfolio exceeds the exercise price of the call, the
writer of the covered call can expect the call to be exercised, so that the writer of the
call must sell the portfolio at the exercise price. Alternatively, if the value of the
portfolio is less than the exercise price, the writer of the call keeps both the portfolio
and the premium paid by the buyer of the call. The trade-off for the writer of the
covered call is the premium income received versus forfeit of any possible capital
appreciation above the exercise price of the call.

5.
Cost Payoff Profit
a. Call option, X = $190.00 $6.75 $5.00 -$1.75
b. Put option, X = $190.00 3.00 0.00 -3.00
c. Call option, X = $195.00 3.65 0.00 -3.65
d. Put option, X = $195.00 5.00 0.00 -5.00
e. Call option, X = $200.00 1.61 0.00 -1.61
f. Put option, X = $200.00 8.09 5.00 -3.09
7. a. From put-call parity:
X 100
P =C S0 + =10 100 + =$7.65
(1 + rf )T
1.10.25

b. Purchase a straddle, i.e., both a put and a call on the stock. The total cost of
the straddle is $10 + $7.65 = $17.65

10. Note that the price of the put equals the revenue from writing the call, net initial
cash outlays = $38.00
Position ST < 35 35 ST 40 40 < ST
Buy stock ST ST ST
Write call ($40) 0 0 40 - ST
Buy put ($35) 35- ST 0 0
Total $35 ST $40

Profit

$2

$35 $40
-$3

12. a.
Outcome ST X ST > X
Stock ST + D ST + D
Put X ST 0
Total X+D ST + D

b.
Outcome ST X ST > X
Call 0 ST X
Zeros X+D X+D
Total X+D ST + D
The total payoffs for the two strategies are equal regardless of whether S T
exceeds X.

c. The cost of establishing the stock-plus-put portfolio is: S0 + P

 The cost of establishing the call-plus-zero portfolio is: C + PV(X + D)
Therefore:
S0 + P = C + PV(X + D)
This result is identical to equation 20.2.

20. a.
Position S T < 190 190 S T 195 S T > 195
Write call, X = $195 0 0 (S T 195)
Write put, X = $190 (190 S T) 0 0
Total S T 190 0 195 S T

Payoff

190 195
ST

Write put Write call

b. Proceeds from writing options:

Call: -$2.99
Put: $1.75
Total: -$1.24
If IBM sells at $198 on the option expiration date, the call option expires in
the moneycash outflow of $3, resulting in a profit of -$1.24. If IBM sells at
$208 on the option expiration date, the call written results in a cash outflow of
$10 at expiration and an overall profit of: -$1.24 $10.00 = -$11.24

c. You break even when either the put or the call results in a cash outflow of
-$1.24. For the put, this requires that:
-$1.24 = $190.00 S T S T = $191.24
For the call, this requires that:
-$1.24 = S T $195.00 S T = $193.76
 d. The investor is betting that IBM stock price will have low volatility. This
position is similar to a straddle.

24. The following payoff table shows that the portfolio is riskless with time-T value
equal to $10:

Position S T 10 S T > 10
Buy stock ST ST
Write call, X = $10 0 (S T 10)
Buy put, X = $10 10 S T 0
Total 10 10
Therefore, the risk-free rate is: ($10/$9.50) 1 = 0.0526 = 5.26%

25. a., b.

Position S T < 100 100 S T 110 S T > 110

Buy put, X = $110 110 S T 110 S T 0
Write put, X = $100 (100 S T) 0 0
Total 10 110 S T 0
The net outlay to establish this position is positive. The put you buy has a
higher exercise price than the put you write, and therefore must cost more than
the put that you write. Therefore, net profits will be less than the payoff at
time T.
27. a., b. (See graph)

This strategy is a bear spread. Initial proceeds = $9 $3 = $6

The payoff is either negative or zero:

Position S T < 50 50 S T 60 S T > 60

Buy call, X = $60 0 0 S T 60
Write call, X = $50 0 (S T 50) (S T 50)
Total 0 (S T 50) 10