Homework 2

Question 1

(1) What is a “butterfly spread”?

Answer: A butterfly spread is a neutral option strategy combining bull and bear spreads. Butterfly spreads
use four option contracts with the same expiration but three different strike prices to create a range of
prices the strategy can profit from. The trader sells two option contracts at the middle strike price and
buys one option contract at a lower strike price and one option contract at a higher strike price. Both
puts and calls can be used for a butterfly spread.

(2) If you believe that the volatility of the underlying will increase in the near future, will you take a long
position in a butterfly spread? Will you take a short position in a butterfly spread?

Answer: If you expect volatility to increase, you should short the butterfly spread.

(3) What is a “straddle”?

Answer: A straddle is an options strategy in which the investor holds a position in both a call and put
with the same strike price and expiration date, paying both premiums. This strategy allows the investor
to make a profit regardless of whether the price of the security goes up or down, assuming the stock
price changes somewhat significantly.

(4) Someone tells you that their current position is long a butterfly (centered at the current spot) and
long an at-the-money straddle, both on the S&P 500. Comment on this trading strategy.

Answer: By longing butterfly and straddle together, earning from butterfly can offset loss from straddle
if price doesn’t change much while not affecting profit from large changes. (FYI, this equals to a strangle.)

Question 2

Today is 1st March and the continuously compounded interest rate is r = 10%. You do all of the following
trades with options on General Electric (GE):
• sell one call on GE with strike $30 and premium $1.55,
• sell one put on GE with strike $30 and premium $0.85,
• buy one put on GE with strike $27.5 and premium $0.30,
• buy one call on GE with strike $32.5 and premium $0.45.
All four options are European and mature on 1st April.

(1) What is the net premium that you collect/pay on 1st March?
Answer: The net premium that you receive in March from (i) writing a strike $30 call, (ii) writing a strike

$30 put, iii) buying a strike $27.5 put, and (iv) buying a strike $32.5 call is $1.55 + $0.85 − $0.30 −
$0.45 = $1.65.

(2) What are the cash flows of this strategy on 1st April? Consider all possible stock prices SApril.
Answer: Let SApril denote the price of GE stock in April.
If SApril ≤ $27.50, then the put you bought and the put you sold are exercised and your net cash flow in

April is $27.5 − SApril − ($30 − SApril) = −$2.50.

If $27.50 < SApril ≤ $30, then only the put you sold is exercised and your net cash flow in April is S April −

$30.

If $30 < SApril ≤ $32.50, then only the call you sold is exercised and your net cash flow in April is $30 −

SApril
If SApril > $32.50, then the call you bought and the call you sold are exercised and your net cash flow in

April is SApril − $32.5 − (SApril − $30) = −$2.50

(3) Determine the profits of this strategy on 1st April and draw a profit diagram (NOT a payoff diagram).
Answer: The future value of the premium collected in March is $1.65e 0.10×1/12 = $1.66. Hence,
your profits are:
Question 3

Shares in XYZ Corporation sell today for $20. The risk-free rate is 3% (continuously compounded). In the
next six months, XYZ shares will either increase in price by 30%, or decrease by 40%.

(1) What is the price of a European call with strike price $19 and expiration in six months?

Answer: An equivalent method is the backward-induction method using the risk neutral pricing approach.
Here, we provide the risk-neutral pricing method. The risk-neutral probability for an up-move in the tree

−0.6) / (1.3−0.6) = 0.593 The prices in the binomial tree are either 20 × 1.3 =
0.03×1/2
described is q = (e

$26 or 20 × 0.6 = $12 after 6 months, and 20 × 1.3 2 = $33.8, or 20 × 1.3 × 0.6 = $15.6 , or 20 × 0.6 2

= $7.2 after a year. CE (T = 6 months) = e −0.03×1/2 × q × (26 − 19) = $4.09

(2) What is the price of a European put with strike price $19 and expiration in six months?

Answer: PE (T = 6 months) = e −0.03×1/2 × (1 − q) × (19 − 12) = $2.81

(3) If the put from point (2) currently trades for $1, is there an arbitrage? If so, describe one. If not, why?

Answer: You should buy the put (it is underpriced), and hedge by selling a synthetic put.

In standard notation, the ∆ of the put is ∆put = (0 − (19 − 12)) / (26 – 12) = − 0.5. That is, you

should sell – 0.5 a share, i.e., buy 0.5 a share. So, your cash flow today is −1 – 0.5 × 20 = −11, while

your cash flow in six months is either 0 + 0.5 × 26 = 13 (after an up movement) or 19 − 12 + 0.5 × 12

= 13 (after a down movement). So, you have a certain six-month return of $2 on an $11 initial investment,
which clearly beats the risk-free rate of 3%.

Question 4

Shares in XYZ Corporation sell today for $20. The risk-free rate is 3% (continuously compounded). In the
next six months, XYZ shares will either increase in price by 30%, or decrease by 40%. In the following six
months, XYZ shares will again either increase in price by 30%, or decrease in price by 40%. XYZ pays no
dividends.

(1) What is the price of a European call with strike $19 and expiration in one year? Use a binomial tree.

(Below is an example answer from your homework for your reference.)

(Below is an example answer from your homework for your reference.)

(3) Now obtain the prices of these call and put options using risk-neutral probabilities. Verify that
you get the same answers as in (1) and (2).

(Below is an example answer from your homework for your reference.)

A share in stock ZZ currently trades at $80. The volatility of the stock price is 25% and the expected
return on this stock is 12%. The continuously compounded risk-free rate is 3%. Assume that the volatility,
the expected rate of return, and the risk-free rate are constant, and that ZZ pays no dividends

(1) Find the prices of an at-the-money European call and an at-the-money European put with
maturity six months for different steps h in the tree (h=T/N). Consider N=5, N=10, N=50, and
N=100 and use the spreadsheet BinomialTree that is on Canvas.

(2) What value of N is needed to get the price from the tree within a cent to the true Black-Scholes-
Merton price?

(3) Find the Black-Scholes Delta’s and Gamma’s of these two options
(Below is an example answer from your homework for your reference.)

Question 6

The spot exchange rate of the Canadian dollar (CAD) is 0.95 USD, with implied volatility of 10%. The risk-
free interest rates in Canada and the United States are 2% and 1% (continuously compounded),
respectively.
(1) Find the price of a one-year European call: right to buy one CAD for 0.98 USD

(2) Find the price of a one-year European put: right to sell one CAD for 0.98 USD

(3) Find the price of an option to buy 0.98 USD with one CAD in one year

(We have not seen currency options in class. However, they can also be priced using the BSM model.
The only thing you need to do is to treat the interest rate on one of the currencies as a dividend yield.
You have to decide on which currency. Give a one-sentence explanation for your decision.)
Question 7

The option market does not allow for arbitrage, and the price of stock ZZ is $100. The price of a European
put option written on ZZ with a strike of $100 is $10. The price of a European put with the same maturity
written on ZZ with a strike of $50 is:
(1) lower than $5
(2) equal to $5
(3) higher than $5
(4) we can’t tell
(5) none of the above
Do NOT try to use any involved calculation, and certainly NOT the Black-Scholes formula (note that we
are not given several of its inputs). Just pointing to one of the five given answers, even if correct, will
NOT count. We want to see your logic. You may support this logic with a picture.

Answer: lower than $5

Question 8

I have posted on Canvas a paper titled "The Chinese Warrants Bubble", and you may recognize one of
the authors – Jialin Yu is a professor in the Finance department at HKUST. The paper has a lot of
discussions related to various academic theories, etc., which certainly are beyond what we do in class, so
please IGNORE them. Just go quickly over the paper to get an idea of what it is about. Then answer the
following questions:

(1) What is the paper’s main finding?

(2) On page 2731 they say that in China the stock price is not allowed to drop more than 10% each
day, so today’s price imposes a floor on the possible price at expiration. How would you calculate
this floor?
(3) On page 2729 they say: "We use Wu Liang stock’s daily closing price and the previous one-year
rolling daily return volatility to compute the warrant’s Black-Scholes value". Do you see any
problem with that?

(4) The paper makes two warnings (caveats) against relying too much on Black-Scholes. Which are
they?

(There is no sample answer. We accept answers which make sense. Below is an example answer from
your homework for your reference.)