Answers To Problem Sets: Valuing Options

Chapter 21 - Valuing Options
CHAPTER 21
Valuing Options
The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.
Answers to Problem Sets
1. a. First it is necessary to find the probabilities of a rise and a fall. Using the
risk-neutral method:
(p × 20) + (1 − p)(−16.7) = 1
p = .4823, or 48%
1 – p = .5177, or 52%
There is a 48% chance that the stock price will rise by 20% (or by $8) and
a 52% chance that the option will be worth $0 when the option matures.
Therefore, the value of call is:
C = [(.48 × $8) + (.52 × $0)] / 1.01

C = $3.82
b. Delta = spread of option prices / spread of stock prices

Delta = ($8 – 0) / ($48 – 33.32)
Delta = .545
c.
Current Possible Future
Cash Flow Cash Flows
Buy call –$3.82 $8.00 $0.00
Buy .545 shares –$21.80 $26.16 $18.16

Borrow $17.98 17.98 –18.16 –18.16
–$3.82 $8.00 $0.00
d. Possible stock prices with call option prices in parentheses:
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Option prices were calculated as follows:
Month 1-a: Call = (.48 × 0 + .52 × 0) / 1.01 = 0
Month 1-b: Call = (.48 × 17.6 + .52 × 0) / 1.01 = 8.4
Month 0: Call = (.48 × 0 + .52 × 8.4) / 1.01 = 4.0
e. Delta = spread of option prices / spread of stock prices

Delta = (8.4 – 0) / (48 – 33.3)
Delta = .572

Est. Time: 11 - 15
2. a. No; The maximum delta is 1.0.

b. No.
c. Delta increases
d. Delta increases
Est. Time: 01 - 05
3. Using the replicating-portfolio method:

a. If month 3 stock price = 452.62, delta = (79.97 − 0)/(529.97 − 386.54)
= .5576.
To replicate call, buy.5576 shares, and borrow PV of those shares if stock
declines; PV(386.54 × .5576).
Option value =.5576 × 452.62 − 215.52/1.004988 = 37.91
b. If month 3 stock price = 620.58, delta = (276.63− 79.97)/(726.63 – 529.97)

= 1.
To replicate call, buy 1 share, and borrow PV of those shares if stock
declines; PV(529.97-79.97)=PV(450).
Option value = 1 × 620.58 − 450/1.004988 = 172.81
c. At month 0 delta = (172.81 – 37.91)/(620.58 – 452.62) = .8032.

To replicate call, buy.8032 shares, and borrow PV of those shares if stock
declines; PV(452.62 × .8032 − 37.91) = PV(325.61).
Option value =.8032 × 530 – 325.61/1.004988 = 101.68
Using the risk-neutral method:

p × .1709 + (1 – p) × (−0.146) = 0.004988: p =.4765
a. If month 3 stock price = 452.62

Option value = (.4765 × 79.97 +.5235 X 0)/1.004988 = 37.91
b. If month 3 stock price = 620.58

Option value = (.4765 × 276.63 +.5235 × 79.97)/1.004988 = 172.81
c. At month 0 option value = (.4765 × 172.81 +.5235 × 37.91)/1.004988 =

101.68
The put option can be valued using put-call parity:

Value of put = 101.68 + 450/(1.004988)2 – 530 = 17.22
Options (risk-neutral method) Inputs Formula

Google Price 530.00 (given)
Periodic Increase % 17.09% (given)
Periodic Decrease % 14.60% (given)
Exercise 450.00 (given)
6- mo rate 1.0000% (given)
3-mo rate 0.4988% = (1+.01)^(3/6) - 1
Prob. Increase 47.65% = [0.4988% - (-14.60%)] / [17.09% - (-14.60%)]
Prob. Decrease 52.35% = (1 - 47.65%)
Value of Call 101.68 (see Binomial Tree diagram)
Value of Put (Put-Call Parity) 17.22 = 101.68 + 450/(1+.004988)^2 - 530)
Options (replicating portfolio) Inputs Formula

Option delta (upswing) @ 3-mo 1.0000 =(276.63 - 79.97) / (726.63 - 529.97)
Option delta (downswing) @ 3-mo 0.5576 =(79.97 - 0.00) / (529.97 - 386.54)
PV of Borrowed amount (upswing) 447.77 =[(1.0000 x 529.97 - 79.97) / (1+0.004988)]
PV of Borrowed amount (downswing) 214.45 =[(0.5576 x 386.54 - 0.00) / (1+0.004988)]
3-mo value (upswing) $172.81 =1.0000 x 620.58 - 447.77
3-mo value (downswing) $37.91 =0.5576 x 452.62 - 214.45
Option delta @ current time 0.8032 =(172.81 - 37.91) / (620.58 - 452.62)
PV of Borrowed amount 324.00 =[(0.8032 x 452.62 - 37.91) / (1+0.004988)]
Current Option Value $101.68 =0.8032 x 530.00 - 324.00
Est. Time: 06 - 10
4. Increased stock price = $530 × 1 1/3 = $706.67
Increased stock price option value = $706.67 – 530.00 = $176.67
Decreased stock price = $530 × (1 – .25) = $397.50
Decreased stock price option value = $0
Replication portfolio:
Option delta = spread of option prices / spread of stock prices

Option delta = ($176.67 – 0) / ($706.67 – 397.50)
Option delta = .571
Investment amount = option delta × stock price

Investment amount = .571 × $530
Investment amount = $302.86
Loan amount = stock price – investment amount
Loan amount = $530 – 302.86

Loan amount = $227.14
Value of call = value of .571 shares – PV of loan amount

Value of call = (.571 × $530) – ($227.14 / 1.01)
Value of call = $77.96
Risk neutral:
p = (1/3)p + (–.25)(1 – p) = .01

p = .446
1 – p = .554
Value of call = (.446 × $176.67 + .554 × 0) / 1.01

Est. Time: 06-10
5. a. Delta = spread of possible option prices / spread of possible share prices

Delta = ($100 – 0) / ($200 − 50)
Delta = .6667
b.
Current Possible Future
Cash Cash Flows
Flow
Buy call –$36.36 $0 $100
Buy .6667 shares –$66.67 $33.33 $133.33

Borrow $30.30 30.30 –33.33 –33.33
–$36.36 $0 $100.00
c. (p × 1.00) + (1 – p)(–.50) = .10

p = .40
d. Value of call = [(.40 × $100) + (.60 × $0)] / 1.10

e. No; The true probability of a price rise is almost certainly higher than the
risk-neutral probability, but it does not help to value the option.
Est. Time: 11 - 15

6. a. P = 60; EX = 60; σ = .06; t = 3; rf = .01 (monthly)
d1= log[P / PV(EX)] / σt.5 + σt.5/ 2

d1= log[60 / (60 / 1.013)] / (.06 × 3.5) + .06 × (3.5/ 2)
d1= .3392
d2 = d1 – σt.5
d2 = .3392 – .06 × 3.5
d2 = .2353
N(d1) = .6328
N(d2) = .5930
Call value = [N(d1)  P] – [N(d2)  PV(EX)]

Call value = [.6328  $60] – [.5930  ($60 / 1.013)]
Call value = $3.43
b. Put value = call value + PV(exercise price) – stock price

Put value = $3.44 + $60 / 1.013 – $60
Put value = $1.67
To replicate either option, you buy or sell delta shares and borrow or lend the
difference.

Est. Time: 06 - 10
7. True. As the stock price rises, the risk of the (call) option falls.

Est. Time: 01 - 05
8. a. You would exercise early if the stock price was sufficiently low. There may
be little opportunity for further gains in the option value, and it would be
better to invest the exercise price to earn interest.
b. Don’t exercise early. The interest savings (10%) from delaying payment of
the exercise price is larger than the dividend forgone ($5, or only 5%).
c. If the stock price and dividend are sufficiently high, it may pay to exercise
early to capture the dividend.
Est. Time: 06 - 10
u = e 0.24 √ 0 .5 = 1.185 ; d = 1/u = 0.844
9. a. If the stock moves up or down every six months, the tree can be
constructed as follows:
$63.19
$53.33
$45.01
$45
$45.01
$37.98
$32.06
If the tree moves up or down every three months, the tree can be constructed as
follows:
u = e 0.24 √ 0 .25 = 1.127 ; d = 1/u = 0.887
b. A larger standard deviation makes the range of possible prices greater, as

shown in the following trees—the first showing possible prices if the price
changes every six months, the second showing prices if they change every three
months.
u = e 0.3 √ 0.5 = 1.236 , d = 1/u = 0.809
u = e 0.3 √ 0.25 = 1.162 ; d = 1/u = 0.861
Est. Time: 11 - 15
10. a. Let p equal the probability of a rise in the stock price. Then, if investors
are risk neutral:
(p  .15) + (1 – p)  (–.13) = .10

p = .821
The possible stock prices next period are:
$60  1.15 = $69.00

$60  .87 = $52.20
The value of the put if exercised immediately equals the value of the
put if it is held to the next period. So, letting X equal the break-even
exercise price, we find:
X – $60 = [(.821)($0) + (1 – .821)(X – $52.20)] / 1.10

X = $61.51
b. If the interest rate is increased, the value of the put option will decrease.
Est. Time: 06 - 10
11. a. The future stock prices of Moria Mining are:
100
With dividend 80 125
Ex-dividend 60 105
48 75 84 131.25
Let p equal the probability of a rise in the stock price. Then, if investors
are risk neutral:
(p  0.25) + (1 – p)  (–0.20) = 0.10
p = 0.67
Now, calculate the expected value of the call in month 6.
If stock price decreases to $80 in month 6, then the call is worthless. If

stock price increases to $125, then, if it is exercised at that time, it has a
value of ($125 – $80) = $45. If the call is not exercised, then its value is:
(0 .67× $ 51 .25 ) + (0. 33×$ 4 )
=$ 32 . 42
1 . 10
Therefore, it is preferable to exercise the call.

The value of the call in month 0 is:
(0 .67× $ 45 )+(0 .33×$ 0 )
= $ 27 . 41
b. 1. 10 of Moria Mining are:
The future stock prices
100
With dividend 80 125
Ex-dividend 64 100
51.2 80 125
Let p equal the probability of a rise in the price of the stock. Then, if
investors are risk neutral:
(p  0.25) + (1 – p)  (–0.20) = 0.10
p = 0.67
Now, calculate the expected value of the call in month 6.
If stock price decreases to $80 in month 6, then the call is worthless. If

stock price increases to $125, then, if it is exercised at that time, it has a
value of ($125 – $80) = $45. If the call is not exercised, then its value is:
(0 .67× $ 45 ) + (0 .33×$ 0 )
=$ 27 . 41
1. 10
Therefore, it is preferable to exercise the call.
The value of the call in month 0 is:
(0 .67× $ 45 )+(0 . 33×$ 0 )
= $ 27 . 41
1 .10
Est. Time: 11 - 15
12. a. The possible prices of Buffelhead stock and the associated call option
values (shown in parentheses) are:
220
(?)
110 440
(?) (?)
55 220 880
(0) (55) (715)
are risk neutral:
p(1.00) + (1 – p) × (–.50) = .10

p = .4
If the stock price in month 6 is $110, the option will not be exercised. So,
the option value will be
Option value = [(.4  ($55) + (.6  $0)] / 1.10

Option value = $20
Similarly, if the stock price is $440 in month 6, then, if it is exercised, it

will be worth ($440 - 165) = $275. If the option is not exercised, it will
be worth:
Option value = [(.4  $715) + (.6  $55)] / 1.10

Option value = $290
Therefore, the call option will not be exercised. Thus, the value of the call
today is:
Option value = [(.4  $290) + (.6  $20)] / 1.10

Option value = $116.36
b. If the price rises to $440:
Delta = spread of possible option prices / spread of possible stock prices

Delta = ($715 – 55) / ($880 – 220)
Delta = 1.00
If the price falls to $110:
Delta = ($55 – 0) / ($220 – 55)

Delta = .33
c. The option delta is 1.0 when the call is certain to be exercised and is
zero when it is certain not to be exercised. If the call is certain to be
exercised, it is equivalent to buying the stock with a partly deferred
payment. So a one-dollar change in the stock price must be matched by
a one-dollar change in the option price. At the other extreme, when the
call is certain not to be exercised, it is valueless, regardless of the
change in the stock price.
d. If the stock price is $110 at six months, the option delta is .33, as shown in
part b. Therefore, in order to replicate the stock, we buy 3 calls and lend
$50, as follows: (Note: In the algo versions in Connect, partial calls are
permitted.)
Initial Stock Stock

Outlay Price = 55 Price = 220
Buy 3 calls -60 0 165
Lend PV(55) -50 55 55
-110 55 220
This strategy is equivalent to:
Buy stock -110 55 220
Est. Time: 15 - 20
13. a. Yes, it is rational to consider the early exercise of an American put option.
It can sometimes pay to exercise an American put before maturity in order
to reinvest the exercise price.
b. The possible prices of Buffelhead stock and the associated American put
option values (shown in parentheses) are:
220
(?)
110 440
(?) (?)
55 220 880
(165) (0) (0)
are risk neutral:
p(1.00) + (1 – p) × (–.50) = .10

p = .4
If the stock price in month 6 is $110, and if the American put option is not
exercised, it will be worth:
Put value = [(.4  $0) + (.6  $165)] / 1.10

Put value = $90
On the other hand, if it is exercised after six months, it is worth $110 (=

$220 – 110). Thus, the investor should exercise the put early.
Similarly, if the stock price in month 6 is $440, and if the American put
option is not exercised, it will be worth:
Put value = [(.4  $0) + (.6  $0)] / 1.10 = $0
On the other hand, if it is exercised after six months, it will cost the
investor $220. The investor should not exercise early.
Finally, the value today of the American put option is:
Put value = [(.4  $0) + (.6  $110)] / 1.10

Put value = $60
c. Unlike the American put in part b, the European put cannot be exercised prior to
expiration. We noted in Part b that, if the stock price in month 6 is $110, the
American put would be exercised because its value if exercised (i.e., $110) is
greater than its value if not exercised (i.e., $90). For the European put, however,
the value at that point is $90 because the European put cannot be exercised
early. Therefore, the value of the European put is:
Put value = [(.4  $0) + (.6  $90)] / 1.10

Put value = $49.09
Est. Time: 11 - 15
14. a. The following tree shows stock prices, with American option values in
parentheses:
With dividend
Ex-dividend
are risk neutral:
p(1.00) + (1 – p) × (–.50) = .10

p = .4
Option value calculations:
The option values in month 6, if the option is not exercised, are:
Option value = [(.4 × $5) + (.6 × $0)] / 1.10

Option value = [(.4 × $665) + (.6 × $42.50)] / 1.10

Option value = $265
If the stock price in month 6 is $110, then it would not pay to exercise
the option. If the stock price in month 6 is $440, then the call is worth:
Call value = ($440 – 165)

Call value = $275
Therefore, the option would be exercised at that time.
Working back to month 0, we find the option value as:
Option value = [(.4 × $275) + (.6 × $1.82)] / 1.10

b. If the option were European, it would not be possible to exercise early.

Therefore, if the price rises to $440 at month 6, the value of the option
is $265. Thus, the current option value is:
Option value = [(.4 × $265) + (.6 × $1.82)] / 1.10

As expected, the European call is less valuable than the American call.
Est. Time: 11 - 15
15. The following tree (see Problem 12) shows stock prices, with the values for the
option in parentheses:
The put option is worth $55 in month 6 if the stock price falls and $0 if the stock
price rises. Thus, with a six-month stock price of $110, it pays to exercise the put
(value = $55). With a price in month 6 of $440, the investor would not exercise
the put since it would cost $275 to exercise. The value of the option in month 6,
if it is not exercised, is determined as follows:
(0 .4×$ 715) + (0 . 6× $ 55 )
= $ 290
1 . 10
Therefore, the month 0 value of the option is:
(0 . 4×$ 290) + (0 . 6×$ 55 )

Option value = = $135 . 45
1 . 10
Est. Time: 11 - 15
16. a. The following tree shows stock prices (with European put option values in
parentheses):
100 (2.34)
90.0 (7.14) 111.1 (.55)
81.0 100 123.4

(21) (2) (0)
Let p equal the probability that the stock price will rise. Then, for a risk-
neutral investor:
(p  .111) + (1 – p)  (–.10) = .05

p = .71
If the stock price in month 6 is C$111.1, then the value of the European
put is:
Put value = (.71 × C$0 + .29 × C$2) / 1.05

Put value = C$.55
If the stock price in month 6 is C$90.0, then the value of the put is:
Put value = (.71 × C$2 + .29 × C$21) / 1.05

Put value = C$7.14
Since this is a European put, it cannot be exercised at month 6.
The value of the put at month 0 is:
Put value = (.71 × C$.55 + .29 × C$7.14) / 1.05

Put value = C$2.34
b. Since the American put can be exercised at month 6, then, if the stock
price is C$90.0, the put is worth (C$102 – 90.0) = C$12.00 if exercised,
compared to C$7.14 if not exercised. Thus, the value of the American put
in month 0 is:
Put value = (.71 × C$.55 + .29 × C$12) / 1.05

Put value = C$3.68
Because an American put can be exercised at any time, it has greater

value than the European put.
Est. Time: 16 - 20
17. a. P = 200 EX = 180  = 0.223 t = 1.0 rf = 0.21

d 1 =log [P/PV (EX)]/σ √ t+ σ √ t /2
= log[ 200/(180/1.21)]/(0.223× √1.0)+(0.223× √1.0) /2=1.4388
d 2 =d 1 −σ √ t=1. 4388−( 0.223× √1.0)=1.2158
N(d1) = N(1.4388) = 0.9249
N(d2) = N(1.2158) = 0.8880
= [0.9249  200] – [0.8880  (180/1.21)] = $52.88
b.
1+upside change=u=eσ √ h=e0 . 223 √ 1. 0 =1. 2498
1+downside change =d=1/u=1/1. 2498=0 .8001
neutral investor:
(p  0.25) + (1 – p)  (–0.20) = 0.21
p = 0.91
In one year, the stock price will be either $250 or $160, and the option
values will be $70 or $0, respectively. Therefore, the value of the
option is:
(0 . 91×7 0 ) + ( 0. 09×0)
=$52 . 64
1 .21
c.
1+upside change=u=eσ √ h=e0 . 223 √ 0. 5 =1. 1708
1+downside change =d=1/u=1/1. 1708=0. 8541
neutral investor:
(p  0.171) + (1 – p)  (–0.146) = 0.10
p = 0.776
The following tree gives stock prices, with option values in parentheses:
Option values are calculated as follows:
1. (0 .776× $ 20 ) + (0 . 224×$ 0 )
= $14 . 11
1 .10
2. (0 .224× $ 20 ) + (0 .776× $ 94 . 2)
= $70. 53
1 .10
3. (0 .224× $ 14 . 11) + (0 . 776× $ 70 .53 )

= $52. 63
1. 10
d. (i) spread of possible option prices

Option delta =
spread of possible stock prices
70 .53 − 14 .11
Option delta = = 0 . 89
234. 2 − 170. 8
To replicate a call, buy 0.89 shares and borrow:

[(0.89  $170.8) – $14.11]/1.10 = $125.37
(ii) 94 .2 − 20
Option delta = = 1. 00
274 .2 − 200
To replicate a call, buy one share and borrow:
[(1.0  $274.2) – $94.2]/1.10 = $163.64
(iii) 20 − 0
Option delta = = 0 .37
200 − 145 .9
To replicate a call, buy 0.37 shares and borrow:
[(0.37  $200) – $20]/1.10 = $49.09
Est. Time: 16 - 20
18. To hold time to expiration constant, we will look at a simple one-period binomial
problem with different starting stock prices. Here are the possible stock prices:
Now consider the effect on option delta:

Current Stock Price
Option Deltas 100 110
In-the-money (EX = 60) 140/150 = 0.93 160/165 = 0.97
At-the-money (EX = 100) 100/150 = 0.67 120/165 = 0.73
Out-of-the-money (EX = 140) 60/150 = 0.40 80/165 = 0.48
Note that, for a given difference in stock price, out-of-the-money options result in
a larger change in the option delta. If you want to minimize the number of times
you rebalance an option hedge, use in-the-money options.
Est. Time: 11 - 15
19. a-1. Option beta at an exercise price of $530:
P = 530 EX = 530  = .3156 t = .5 rf = .01 (6 month)

Stock beta = 1.15 Risk-free loan beta = 0
d1= log[P / PV(EX)] / σt.5 + σt.5/ 2

d1= log[530 / (530 / 1.01)] / (.3156 × .5.5) + .3156 × (.5.5/ 2)
d1= .1562
d2 = d1 – σt.5
d2 = .1562 – .3156 × .5.5
d2 = –.0670
N(d1) = .5621
N(d2) = .4733

Call value = [.5621  $530] – [.4733  ($530 / 1.01)]
Call value = $297.89 – 248.36
Call value = $49.52
We are investing $297.89 and borrowing $248.36:
Option beta = (297.89 × 1.15 – 248.36 × 0) / (297.89 – 248.36)

Option beta = 6.92
a-2. Now, lower the exercise price and observe the change in the option beta:
P = 530 EX = 450  = .3156 t = .5 rf = .01 (6 month)
d1= log[P / PV(EX)] / σt.5 + σt.5/ 2

d1= log[530 / (450 / 1.01)] / (.3156 × .5.5) + .3156 × (.5.5/ 2)
d1= .8894
d2 = d1 – σt.5
d2 = .8894 – .3156 × .5.5
d2 = .6662
N(d1) = .8131
N(d2) = .7474

Call value = [.8131  $530] – [.7474  ($450 / 1.01)]
Call value = $430.95 – 332.99
Call value = $97.96
Option beta = (430.95 × 1.15 – 332.99 × 0) / (430.95 – 332.99)

Option beta = 5.06
The option beta decreases as the exercise price decreases indicating a

reduction in risk.
b. Go back to the original exercise price but extend the time period:
P = 530 EX = 530  = .3156 t=1 rf = .0201 (annual)
d1= log[P / PV(EX)] / σt.5 + σt.5/ 2
d1= log[530 / (530 / 1.0201)] / (.3156 × 1.5) + .3156 × (1.5/ 2)

d1= .2209
d2 = d1 – σt.5
d2 = .2209 – .3156 × 1.5
d2 = –.0947
N(d1) = .5874
N(d2) = .4623

Call value = [.5874  $530] – [.4623  ($530 / 1.0201)]
Call value = $311.32 – 240.17
Call value = $71.15
Option beta = (311.32 × 1.15 – 240.17 × 0) / (311.32 – 240.17)

Option beta = 5.03
Risk also decreases as the maturity is extended.
Est. Time: 16 - 20
20. a. The call option; You would delay the exercise of the put until after the
dividend has been paid and the stock price has dropped.
b. The put option; You never exercise a call if the stock price is below
exercise price.
c. The put when the interest rate is high; You can invest the exercise price.
Est. Time: 01 - 05
21. a. When you exercise a call, you purchase the stock for the exercise price.
Naturally, you want to maximize what you receive for this price, and so
you would exercise on the with-dividend date in order to capture the
dividend.
b. When you exercise a put, your gain is the difference between the price of
the stock and the amount you receive upon exercise, i.e., the exercise
price. Therefore, in order to maximize your profit, you want to minimize
the price of the stock and so you would exercise on the ex-dividend date.
Est. Time: 01 - 05
22. P = 30 EX = 45.25  = .41 t=7 rf = .05 (annual)
d1= log[P / PV(EX)] / σt.5 + σt.5/ 2

d1= log[30 / (45.25 / 1.057)] / (.41 × 7.5) + .41 × (7.5/ 2)
d1= .4783
d2 = d1 – σt.5
d2 = .4783 – .41 × 7.5
d2 = –.6064
N(d1) = .6838
N(d2) = .2721

Call value = [.6838  $30] – [.2721  ($45.25 / 1.057)]
Call value = $11.76
Est. Time: 01 - 05
23. Individual exercise; answers will vary.
Est. Time: 06 - 10
24. For the one-period binomial model, assume that the exercise price of the options
(EX) is between u and d. Then, the spread of possible option prices is:
For the call: [(u – EX) – 0]
For the put: [(d – EX) – 0]
The option deltas are:
Option delta(call) = [(u – EX) – 0]/(u – d) = (u – EX)/(u – d)
Option delta(put) = [(d – EX) – 0]/(u – d) = (d – EX)/(u – d)
Therefore:
[Option delta(call) – 1] = [(u – EX)/(u – d)] – 1
= [(u – EX)]/(u – d)] – [(u – d)/(u – d)]
= [(u – EX) – (u – d)]/(u – d)
= [d – EX]/(u – d) = Option delta(put)
Est. Time: 06 - 10
25. If the exercise price of a call is zero, then the option is equivalent to the stock so
that, in order to replicate the stock, you would buy one call option. Therefore, if
the exercise price is zero, the option delta is one. If the exercise price of a call is
indefinitely large, then the option value remains low even if there is a large
percentage change in the price of the stock. Therefore, the dollar change in the
value of the option will be much smaller than the dollar change in the price of the
stock, so that the option delta is close to zero. Between these two extreme
cases, the option delta varies between zero and one.
Est. Time: 06 - 10
26. Both of these announcements may convey information about company prospects
and thereby affect the price of the stock. But, when the dividend is paid, stock
price decreases by an amount approximately equal to the amount of the
dividend. This price decrease reduces the value of the option. On the other
hand, a stock repurchase at the market price does not affect the price of the
stock. Therefore, you should hope that the board will decide to announce a stock
repurchase program.
Est. Time: 06 - 10
27. a. Using the figures in Section 21-3, beta = 1.28
b.
P = 400 EX = 400  = 0.3156 t = 1.0 rf = 0.035 (annually)
d 1 =log [P/PV (EX)]/σ √ t+ σ √ t /2
= log[ 400/( 400/1.035 )]/(0.3156× √1)+(0.3156× √1) /2=0.2668
d 2=d 1 −σ √ t=0.2668−( 0.3156× √ 1)=−0.0488
N(d1) = 0.6052
N(d2) = 0.4805
= [0.6052  400] – [0.4805  (400/1.035)]
= $242.08 – 185.70
= $56.38
The call value has increased with the longer time period. Since we are
borrowing 186 (beta = 0) and investing 242 in the stock (beta = 1.28), the
risk of this call option can be calculated as:
= (−186  0 + 242  1.28)/(−186 + 242)

= 5.53
c. From the put-call parity relationship:

Value of call + present value of exercise price = value of put + share price
Value of put = value of call + PV(EX) – share price
Thus, to replicate the payoffs for the put, you would buy a call with an
exercise price of $400, invest the present value of the exercise price, and
sell the stock short.
The risk of this position can thus be calculated as:
= [(56.38  5.53) + (400/1.035  0) – 400  1.28)]/ (56.38 +

(400/1.035) – 400)
= -4.67
d. One share stock plus one put option
This is the same as the previous problem except the stock positions
cancel out, leaving us with a call at an exercise price of $400 and our
investment in the present value of the exercise price.
= [(56.38  5.53) + (400/1.035  0)/(56.38 + 400/1.035)

= 0.704
We have partially hedged our position.
e. One share stock plus one put option minus one call option
This is the same as the previous problem except the call positions cancel
out, leaving us with our investment in the present value of the exercise
price.
= (400/1.035  0)/(400/1.035)
= 0.00
We have reduced our position to a risk-free loan.
Est. Time: 16 - 20
28. a. The beta of both the call and the put for options can be calculated by
examining the replicating portfolio. To replicate a call option on Google
stock, we borrowed $233.22 and invested $294.44 in Google stock.
Therefore, the beta is 1.15 x 294.44/[294.44 + (-233.22)] = 5.53.
b. To replicate the put option, we sold $235.56 of Google stock short and lent
$291.52, so the beta is 1.15 × (-235.56)/[(-235.56) + 291.52] = (-4.84).
c. The value (i.e. weight) of the call option is $61.22 and value of the bank
loan is $524.75. Therefore, the beta of the portfolio is the weighted
average of call beta of 5.53 and the loan beta of zero, as follows 5.53 ×
61.22/(61.22 + 524.75) = 0.58.
d. The value (i.e. weight) of the put option is $55.96 and value of the stock
share is $530. Therefore, the beta of the portfolio is the weighted average
of put beta of (-4.84) and the stock beta of 1.15, as follows [1.15 ×
530.00/(530.00 + 55.96)] + [(-4.84) × 55.96/(55.96 + 530.00)] = 0.58.
e. C and D each represent one side of the put-call parity equation:

[Call + PV(exercise price)] = [put + stock price]
Therefore, for the equality to hold true, our answer to D and C must equal.
Est. Time: 06 - 10

Answers To Problem Sets: Valuing Options

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Chapter 21 - Valuing Options

Answers to Problem Sets

Therefore, the value of call is:

C = [(.48 × $8) + (.52 × $0)] / 1.01

b. Delta = spread of option prices / spread of stock prices

Buy .545 shares –$21.80 $26.16 $18.16

d. Possible stock prices with call option prices in parentheses:

Option prices were calculated as follows:

Month 1-a: Call = (.48 × 0 + .52 × 0) / 1.01 = 0

Month 1-b: Call = (.48 × 17.6 + .52 × 0) / 1.01 = 8.4

Month 0: Call = (.48 × 0 + .52 × 8.4) / 1.01 = 4.0

e. Delta = spread of option prices / spread of stock prices

2. a. No; The maximum delta is 1.0.

3. Using the replicating-portfolio method:

Option value =.5576 × 452.62 − 215.52/1.004988 = 37.91

b. If month 3 stock price = 620.58, delta = (276.63− 79.97)/(726.63 – 529.97)

Option value = 1 × 620.58 − 450/1.004988 = 172.81

c. At month 0 delta = (172.81 – 37.91)/(620.58 – 452.62) = .8032.

Option value =.8032 × 530 – 325.61/1.004988 = 101.68

Using the risk-neutral method:

a. If month 3 stock price = 452.62

b. If month 3 stock price = 620.58

c. At month 0 option value = (.4765 × 172.81 +.5235 × 37.91)/1.004988 =

The put option can be valued using put-call parity:

Options (risk-neutral method) Inputs Formula

Options (replicating portfolio) Inputs Formula

4. Increased stock price = $530 × 1 1/3 = $706.67

Increased stock price option value = $706.67 – 530.00 = $176.67

Decreased stock price = $530 × (1 – .25) = $397.50

Decreased stock price option value = $0

Option delta = spread of option prices / spread of stock prices

Investment amount = option delta × stock price

Loan amount = $530 – 302.86

Value of call = value of .571 shares – PV of loan amount

p = (1/3)p + (–.25)(1 – p) = .01

Value of call = (.446 × $176.67 + .554 × 0) / 1.01

Est. Time: 06-10

5. a. Delta = spread of possible option prices / spread of possible share prices

Buy .6667 shares –$66.67 $33.33 $133.33

c. (p × 1.00) + (1 – p)(–.50) = .10

d. Value of call = [(.40 × $100) + (.60 × $0)] / 1.10

d1= log[P / PV(EX)] / σt.5 + σt.5/ 2

Call value = [N(d1)  P] – [N(d2)  PV(EX)]

b. Put value = call value + PV(exercise price) – stock price

u = e 0.24 √ 0 .5 = 1.185 ; d = 1/u = 0.844

b. A larger standard deviation makes the range of possible prices greater, as

u = e 0.3 √ 0.5 = 1.236 , d = 1/u = 0.809

u = e 0.3 √ 0.25 = 1.162 ; d = 1/u = 0.861

(p  .15) + (1 – p)  (–.13) = .10

The possible stock prices next period are:

$60  1.15 = $69.00

X – $60 = [(.821)($0) + (1 – .821)(X – $52.20)] / 1.10

11. a. The future stock prices of Moria Mining are:

With dividend 80 125

If stock price decreases to $80 in month 6, then the call is worthless. If

Therefore, it is preferable to exercise the call.

If stock price decreases to $80 in month 6, then the call is worthless. If

p(1.00) + (1 – p) × (–.50) = .10

Option value = [(.4  ($55) + (.6  $0)] / 1.10