Problem 1.35.

The current price of a stock is $94, and three-month call options with a strike price of
$95 currently sell for $4.70. An investor who feels that the price of the stock will
increase is trying to decide between buying 100 shares and buying 2,000 call options
(20 contracts). Both strategies involve an investment of $9,400. What advice would
you give? How high does the stock price have to rise for the option strategy to be
more profitable?

The investment in call options entails higher risks but can lead to higher returns. If
the stock price stays at $94, an investor who buys call options loses $9,400 whereas
an investor who buys shares neither gains nor loses anything. If the stock price rises
to $120, the investor who buys call options gains
2000  (120 − 95) − 9400 = $40 600
An investor who buys shares gains
100  (120 − 94) = $2 600
The strategies are equally profitable if the stock price rises to a level, S, where
100  ( S − 94) = 2000( S − 95) − 9400
or
S = 100
The option strategy is therefore more profitable if the stock price rises above $100.

Problem 2.26
Explain what is meant by open interest. Why does the open interest usually decline
during the month preceding the delivery month? On a particular day, there were
2,000 trades in a particular futures contract. This means that there were 2,000
buyers (going long) and 2,000 sellers (going short). Of the 2,000 buyers, 1,400 were
closing out positions and 600 were entering into new positions. Of the 2,000 sellers,
1,200 were closing out positions and 800 were entering into new positions. What is
the impact of the day’s trading on open interest?

Open interest is the number of contract outstanding. Many traders close out their
positions just before the delivery month is reached. This is why the open interest
declines during the month preceding the delivery month. The open interest went
down by 600. We can see this in two ways. First, 1,400 shorts closed out and there
were 800 new shorts. Second, 1,200 longs closed out and there were 600 new longs.

Problem 2.29.
Suppose that there are no storage costs for crude oil and the interest rate for
borrowing or
lending is 5% per annum. How could you make money if the June and December
futures
contracts for a particular year trade at $80 and $86, respectively.

You could go long one June oil contract and short one December contract. In June
you take delivery of the oil borrowing $80 per barrel at 5% to meet cash outflows.
The interest accumulated in six months is about 80×0.05×0.5 or $2. In December the
oil is sold for $86 per barrel and $82 is repaid on the loan. The strategy therefore
leads to a profit of $4. Note that this profit is independent of the actual price of oil in
June 2010 or December 2009. It will be slightly affected by the daily settlement
procedures.

Problem 4.28.
The 6-month, 12-month. 18-month,and 24-month risk-free zero rates are 4%, 4.5%,
4.75%, and 5% with semiannual compounding.
a) What are the rates with continuous compounding?
b) What is the forward rate for the six-month period beginning in 18 months
c) What is two-year par yield

a) With continuous compounding the 6-month rate is 2ln102 = 0039605 or

3.961%. The 12-month rate is 2ln10225 = 0044501 or 4.4501%. The 18-
month rate is 2ln102375 = 0046945 or 4.6945%. The 24-month rate is
2ln1025 = 0049385 or 4.9385%.
b) The forward rate (expressed with continuous compounding) is from equation
(4.5)
49385  2 − 46945 15
05
or 5.6707%. When expressed with semiannual compounding this is
2(e005670705 − 1) = 0057518 or 5.7518%.
c) The value, A of an annuity paying off $1 every six months is
e−003960505 + e−00445011 + e−004694515 + e−00493852 = 37748
The present value of $1 received in two years, d , is e−00493852 = 090595 .
From the formula in Section 4.6 the par yield is
(100 − 100  090595)  2
= 4983
37748
or 4.983%.
Problem 4.30.
The following table gives the prices of bonds

Bond Principal ($) Time to Maturity Annual Coupon ($)* Bond Price ($)
(yrs)
100 0.5 0.0 98
100 1.0 0.0 95
100 1.5 6.2 101
100 2.0 8.0 104

*Half the stated coupon is paid every six months

a) Calculate zero rates for maturities of 6 months, 12 months, 18 months, and 24

months.
b) What are the forward rates for the periods: 6 months to 12 months, 12
months to 18 months, 18 months to 24 months?
c) What are the 6-month, 12-month, 18-month, and 24-month par yields for
bonds that provide semiannual coupon payments?
d) Estimate the price and yield of a two-year bond providing a semiannual
coupon of 7% per annum.

a) The zero rate for a maturity of six months, expressed with continuous
compounding is 2 ln(1 + 2  98) = 40405% . The zero rate for a maturity of
one year, expressed with continuous compounding is ln(1 + 5  95) = 51293 .
The 1.5-year rate is R where
31e−004040505 + 31e−00512931 + 1031e− R15 = 101
The solution to this equation is R = 0054429 . The 2.0-year rate is R where
4e−004040505 + 4e−00512931 + 4e−005442915 + 104e− R2 = 104
The solution to this equation is R = 0058085 . These results are shown in the
table below

Maturity (yrs) Zero Rate (%) Forward Rate Par Yield (s.a.%) Par yield (c.c %)
(%)
0.5 4.0405 4.0405 4.0816 4.0405
1.0 5.1293 6.2181 5.1813 5.1154
1.5 5.4429 6.0700 5.4986 5.4244
2.0 5.8085 6.9054 5.8620 5.7778
 b) The continuously compounded forward rates calculated using equation (4.5)
are shown in the third column of the table

c) The par yield, expressed with semiannual compounding, can be calculated

from the formula in Section 4.4. It is shown in the fourth column of the table.
In the fifth column of the table it is converted to continuous compounding

d) The price of the bond is

35e−004040505 + 35e−00512931 + 35e−005442915 + 1035e−00580852 = 10213
e) The yield on the bond, y satisfies
35e− y05 + 35e− y10 + 35e− y15 + 1035e− y20 = 10213
f) The solution to this equation is y = 0057723 . The bond yield is therefore
5.7723%.

Problem 5.31.
A company that is uncertain about the exact date when it will pay or receive a foreign
currency may try to negotiate with its bank a forward contract that specifies a period
during which delivery can be made. The company wants to reserve the right to
choose the exact delivery date to fit in with its own cash flows. Put yourself in the
position of the bank. How would you price the product that the company wants?

It is likely that the bank will price the product on assumption that the company
chooses the delivery date least favorable to the bank. If the foreign interest rate is
higher than the domestic interest rate then
1. The earliest delivery date will be assumed when the company has a long
position.
2. The latest delivery date will be assumed when the company has a short
position.
If the foreign interest rate is lower than the domestic interest rate then
1. The latest delivery date will be assumed when the company has a long
position.
2. The earliest delivery date will be assumed when the company has a short
position.
If the company chooses a delivery which, from a purely financial viewpoint, is
suboptimal the bank makes a gain.
Problem 5.32.
A trader owns a commodity as part of a long-term investment portfolio. The trader
can buy the commodity for $950 per ounce and sell it for $949 per ounce. The trader
can borrow funds at 6% per year and invest funds at 5.5% per year. (Both interest
rates are expressed with annual compounding.) For what range of one-year forward
prices does the trader have no arbitrage opportunities? Assume there is no bid–offer
spread for forward prices.

Suppose that F0 is the one-year forward price of the commodity. If F0 is relatively

high, the trader can borrow $950 at 6%, buy one ounce of the commodity and enter
into a forward contract to sell the commodity in one year for F0 . The profit made in
one year is
F0 − 950  1.06 = F0 − 1007

This is profitable if F0 >1007. If F0 is relatively low, the trader can sell one ounce of
the commodity for $949, invest the proceeds at 5.5%, and enter into a forward
contract to buy it back for F0 . The profit (relative to the position the trader would
be in if the commodity were held in the portfolio during the year) is
949  1.055 − F0 = 1001.195

This shows that there is no arbitrage opportunity if the forward price is between
$1001.195 and $1007 per ounce.

Problem 9.26.
The price of a stock is $40. The price of a one-year European put option on the stock
with a strike price of $30 is quoted as $7 and the price of a one-year European call
option on the stock with a strike price of $50 is quoted as $5. Suppose that an
investor buys 100 shares, shorts 100 call options, and buys 100 put options. Draw a
diagram illustrating how the investor’s profit or loss varies with the stock price over
the next year. How does your answer change if the investor buys 100 shares, shorts
200 call options, and buys 200 put options?

Figure S9.5 shows the way in which the investor’s profit varies with the stock price in
the first case. For stock prices less than $30 there is a loss of $1,200. As the stock
price increases from $30 to $50 the profit increases from –$1,200 to $800. Above
$50 the profit is $800. Students may express surprise that a call which is $10 out of
the money is less expensive than a put which is $10 out of the money. This could be
because of dividends or the crashophobia phenomenon discussed in Chapter 19.
 Figure S9.6 shows the way in which the profit varies with stock price in the second
case. In this case the profit pattern has a zigzag shape. The problem illustrates how
many different patterns can be obtained by including calls, puts, and the underlying
asset in a portfolio.

2000
Profit

1000
Stock Price
0
0 20 40 60 80
-1000 Long Stock
Long Put
-2000
Short Call
Total

Figure S9.5 Profit in first case considered Problem 9.23

2000
Profit

1000

Stock Price
0
0 20 40 60 80
-1000
Long Stock
Long Put
-2000
Short Call
Total

Figure S9.6 Profit for the second case considered Problem 9.23

Problem 10.26.
Suppose that c1 , c2 , and c3 are the prices of European call options with strike
prices K1 , K 2 , and K 3 , respectively, where K 3  K 2  K1 and K 3 − K 2 = K 2 − K1 .
All options have the same maturity. Show that
c2  05(c1 + c3 )

(Hint: Consider a portfolio that is long one option with strike price K1 , long one
option with strike price K 3 , and short two options with strike price K 2 .)

Consider a portfolio that is long one option with strike price K1 , long one option
with strike price K 3 , and short two options with strike price K 2 . The value of the
portfolio can be worked out in four different situations
ST  K1  Portfolio Value = 0
K1  ST  K 2  Portfolio Value = ST − K1
K 2  ST  K 3  Portfolio Value = ST − K1 − 2( ST − K 2 ) = K 2 − K1 − ( ST − K 2 )  0
ST  K 3  Portfolio Value = ST − K1 − 2( ST − K 2 ) + ST − K 3 = K 2 − K1 − ( K 3 − K 2 ) = 0
The value is always either positive or zero at the expiration of the option. In the
absence of arbitrage possibilities it must be positive or zero today. This means that
c1 + c3 − 2c2  0
or
c2  05(c1 + c3 )
Note that students often think they have proved this by writing down

c1  S0 − K1e− rT

2c2  2(S0 − K2e− rT )

c3  S0 − K3e− rT

and subtracting the middle inequality from the sum of the other two. But they are
deceiving themselves. Inequality relationships cannot be subtracted. For example,
9  8 and 5  2 , but it is not true that 9 − 5  8 − 2

Problem 10.28.
Suppose that you are the manager and sole owner of a highly leveraged company. All
the 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 will pay off the debt. If the value of the company
is less than the face value of the debt, you will declare bankruptcy and the debt
holders will own the company.

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

b. Express the position of the debt holders in terms of options on the value of the
company.
c. What can you do to increase the value of your position?

a. Suppose V is the value of the company and D is the face value of the
debt. The value of the manager’s position in one year is
max(V − D 0)
This is the payoff from a call option on V with strike price D .
 b. The debt holders get
min(V  D)
= D − max( D − V  0)
Since max( D − V  0) is the payoff from a put option on V with strike price
D , the debt holders have in effect made a risk-free loan (worth D at
maturity with certainty) and written a put option on the value of the
company with strike price D . The position of the debt holders in one year
can also be characterized as
V − max(V − D 0)
This is a long position in the assets of the company combined with a short
position in a call option on the assets with a strike price of D . The
equivalence of the two characterizations can be presented as an application
of put–call parity. (See Business Snapshot 10.1.)
c. The manager can increase the value of his or her position by increasing the
value of the call option in (a). It follows that the manager should attempt to
increase both V and the volatility of V . To see why increasing the volatility
of V is beneficial, imagine what happens when there are large changes in
V . If V increases, the manager benefits to the full extent of the change. If
V decreases, much of the downside is absorbed by the company’s lenders.

(額外課堂證明)

Show the put-call parity for European option underlying dividend

paying stock is

c + D + Ke− rT = p + S0

Ans:

設定投資組合求證

Portfolio A: 1 European call+ cash D+Ke(-rT)

Portfolio C:1 European put + 1Stock S0

依照 到期時 S(T)>K Portfolio A: e(rT)D+S(T)ex Portfolio C: e(rT)D+S(T)ex

S(T)<=K Portfolio A: e(rT)D+K Portfolio C: e(rT)D+K

因此 Portfolio A= Portfolio C.

=> c + D + K𝑒 −𝑟𝑇 = 𝑝 + 𝑆0