20PF53/20MF53 APR 2022

THIAGARAJAR SCHOOL OF MANAGEMENT (AUTONOMOUS)

Guidelines:

• Each student is allotted one company and the entire workings must be done for the same
company only.
• Need to submit an individual report (word format and maximum of 15 pages). The report
must contain the introduction about the company (one paragraph), any observed financials
(maximum one page), interpretations from the options chain, and any strategies you
intend to use while investing in the allotted company.
Questions:
1. Compute the intrinsic values, time values, and lower bounds of any call and put of allotted
stock. Identify any profit opportunities that may exist. Treat these as American options for the
purposes of determining the intrinsic values and time values and European options for the
purpose of determining the lower bounds. Check any combinations of puts and Calls (from the
options chain), and determine whether they conform to the put-call parity rule for European
options. If you see any violations, suggest a strategy. 10 Marks

2. Consider a two-period, two-state world and you are allowed to take the current stock price and
the risk-free rate be 4percent. Each period the stock price can go either up by 20 percent or
down by 20 percent. A call option expiring at the end of the second period has an exercise
price of 10 percent lower value than the current stock price.
a) Find the stock price sequence.
b) Determine the possible prices of the call at expiration.
c) Find the possible prices of the call at the end of the first period.
d) What is the current price of the call?
e) What is the initial hedge ratio? What are the two possible hedge ratios at the end of
the first period?
f) What would an investor do if the call were overpriced? If it were under-priced?
10 Marks
3. Compute the call and put prices for a stock option, where the current stock price (allotted stock
price), the exercise price is 15% above the current price, the risk-free interest rate is 4 percent
(continuously compounded), the volatility is 20 percent, and the time to expiration is 1 year.
Explain the observed relationship between the call and put price. Show how a delta hedge
using a position in the stock and a long position in a put would be set up.
Suppose that the actual call is selling for Rs.50. Suggest a strategy, but do not worry about
hedging the risk. Simply buy or sell 100 calls. After purchasing the call, you investigate your
possible profits. You expect to unwind the position one month later, at which time you expect
the call to have converged to its Black-Scholes-Merton value. Of course, you do not know what
20PF53/20MF53 APR 2022
the stock price will be, but you can calculate the profits for stock prices over a reasonable
range. You expect that the stock will not vary beyond the 20% upward and downward range.
Determine your profit in increments of Rs.10 of the stock price. Comment on your results
15 Marks
4. You bought an at-the-money one-month European call option on allotted stock for Rs.200
(Assumption). The current market price of the stock is up by 10 percent. What would be the
profit or loss of the transaction on the expiry date? If your stock closes at a 10% lower value,
what would be the profit or loss of the trade? At what closing price of expiry, you can reach
the breakeven point? 10 Marks

5. The important consideration in evaluating option strategies is the effect of transaction costs.
Suppose that purchases and sales of an option incur a brokerage commission of 2 percent of
the option’s value. Purchases and sales of a share of stock incur a brokerage commission of 1
of the stock’s value. If the option is exercised, there is a transaction cost on the purchase or
sale of the stock. Determine the profit equations for the following strategies, assuming that
the options are held to expiration and exercised if in-the-money rather than sold back. Assume
that one option and/or share is used and that any shares left in the portfolio are sold. (a) Long
call (b)Long put (c) Covered call (d)Protective put. 15Marks

6.
a) (a)Construct bear money spread using the current spot price and immediate strike price
which expires in April 2022. You are expected to hold the position until the options expire.
Determine the profits and graph the results. Identify the breakeven stock price at
expiration and the maximum and minimum profits. Discuss any special considerations
associated with this strategy.

b) Construct a collar and Iron butterfly strategies. First, use the Black-Scholes-Merton model
to identify a call that will make the collar have zero up-front cost. Then close the position
on 28th April 2022 (expiry date). Use the spreadsheet to find the profits for the possible
stock prices on the expiry date. Generate a graph and use it to identify the approximate
breakeven stock price. Determine the maximum and minimum profits. 20 Marks