Question 1 (10 marks)

Assume dividend paying NPC stock is currently priced at AUD50 and a dividend of AUD 4
will be paid in 3 months. The continuous risk-free interest rate is 10% p.a. The following
table shows the market price of four European options.
Option Type Maturity Strike Market price
price
1 Call 3 months 40 8
2 Call 3 months 50 2
3 Put 3 months 40 1.85
4 Put 3 months 50 4.67

a. Apply the put-call parity and determine which option(s) is/are relatively mis-priced
assuming no-arbitrage. (4 marks)
b. Explain how to construct a strangle using the options displayed in the table. Assume the
market price of NPC stock becomes AUD 80, calculate the payoff on the strangle. (4 marks)
c. Suppose all else remain unchanged and a market shock caused the volatility of NPC stock
to increase, what change (increase, decrease or unchanged) should be expected in the prices
of the options? Why? (2 marks)
Question 2 (10 marks)
a. Suppose that put options on a LYX stock with strike prices AUD 50 and AUD 55, costs AUD 4 and
AUD 7, respectively.

i. Create a bull spread and a bear spread using these options. Then construct a table that shows the
value at expiration and the profit for each of these spreads. (2 marks)

ii. determine the maximum gain and loss that you may achieve from the bull spread. (2 marks)

iii. Determine the break-even stock price for the bear spread. (2 marks)

b. What are the upper bound and the lower bound for the price of a three-month European call
option on a non-dividend paying stock when stock price is $50, the strike price is $40, and the risk-
free interest rate is 8% per annum? (4 marks)
Question 3 (10marks)
The current price of NLT stock is $20 and the volatility of the stock price is 20% per year. Rock Pound
pays no dividends. The continuous risk-free interest rate is 5% p.a., which will remain constant
forever. Construct a two-step binomial tree (estimate u, d and p, keep three decimal places) to
describe the price evolvement of the stock and calculate the price of a 6-month American put option
on Rock Pound stock with a strike price of $18.

Answer:
Question 4 (10 marks)
A stock price is currently $15. Assume that the expected return from the stock is 10% and its
volatility is 15%. The risk-free return is 5% p.a. compounded continuously.
a. What is the probability distribution for the rate of return (with continuous compounding)
earned over a one-year period? (2 marks)
b. What is the probability that a European call option on the stock with an exercise price of
$18 and a maturity date in nigh months will be exercised? (4 marks)
z-score N(z)
0.85 0.802
0.86 0.805
0.87 0.808
0.88 0.811
0.89 0.813
0.9 0.816

c. What is the price of a call option written on this stock with a time to expiration of 1/2 year
and a strike price of $13? (4 marks)
d N(d)
1.53 0.937
1.55 0.939
1.57 0.942
1.59 0.944
1.61 0.946
1.63 0.948
1.65 0.951
Question 5 (10 marks)

A manager in charge of a portfolio worth $500,000 is concerned about the market might decline
rapidly during the next three months. The portfolio is expected to perfectly track the performance of
ASX200. Use the following information to answer questions (a) and (b)

Portfolio beta 1
Current ASX200 index 5000
Risk free return (annual) 6%
Index dividend yield (annual) 3%
Volatility of ASX200 (annual) 25%
size of a European XJO index option on ASX200 10 times the index

(a). Determine a strategy that uses index options as a hedge against the portfolio declining below
$400,000 by specifying the type (call/put) of the option, the position (long/short) in the option, the
number of option contracts and the strike price of the option. (5 marks)

(b). Determine the total cost of the hedge using Black-Scholes-Merton model (i.e. the total cost of the
position as determined in part (a)). Please keep two decimal places for d1 and d2. (5 marks)

d N(d)
1.77 0.962
1.81 0.965
1.84 0.967
1.87 0.969
1.91 0.972
1.93 0.973
1.96 0.975
1.99 0.977
2.02 0.978
Question 6
a. Consider a portfolio that is Delta neutral, with a Gamma of -4500 and a Vega of -8000.
The option shown in the following table can be traded. Explain what positions you should
take in option A, B and the underlying asset to make the portfolio Delta, Gamma and Vega
neutral? (4 marks)
delta gamma vega
Option A 0.6 0.2 1
Option B 0.5 0.9 1.4

b. What does it mean to assert that the delta of a call option is 0.7? Is delta of a call option
constant? Why? (4 marks)
c. Define Theta and describe how it changes with the passage of time. (2 marks)