Scribd
Upload
18 views

Problem Set 3 Solution

This document outlines problems for a corporate finance problem set. It includes 6 problems related to options pricing, arbitrage opportunities, and describing a firm's capital structure using options. Problem 1 involves calculating payoffs for long and short call options on Intuit stock. Problem 2 prices a call using put-call parity. Problem 3 describes an arbitrage opportunity and the strategy to exploit it. Problems 4-6 involve drawing option payoff profiles including for a butterfly spread, collar, and describing a firm's equity and debt as options.

Uploaded by

rtchuidjangnana
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
18 views

Problem Set 3 Solution

This document outlines problems for a corporate finance problem set. It includes 6 problems related to options pricing, arbitrage opportunities, and describing a firm's capital structure using options. Problem 1 involves calculating payoffs for long and short call options on Intuit stock. Problem 2 prices a call using put-call parity. Problem 3 describes an arbitrage opportunity and the strategy to exploit it. Problems 4-6 involve drawing option payoff profiles including for a butterfly spread, collar, and describing a firm's equity and debt as options.

Uploaded by

rtchuidjangnana
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 5

Problem Set 3

Advanced Corporate Finance


Due date: November 2

Problem 1

You own a call option on Intuit stock with a strike price of $40. The option will expire in exactly
three months’ time.
1.a. If the stock is trading at $55 in three months, what will be the payoff of the call?
1.b. If the stock is trading at $35 in three months, what will be the payoff of the call?
1.c. Draw a payoff diagram showing the value of the call at expiration as a function of
the stock price at expiration.

Long call option: value at expiration:


a. $15
b. 0$
c. Draw a graph:

Assume that you have shorted the call with the above characteristics.
2.a. If the stock is trading at $55 in three months, what will you owe?
2.b. If the stock is trading at $35 in three months, what will you owe?
2.c. Draw a payoff diagram showing the amount you owe at expiration as a function
of the stock price at expiration.

Short call: value at expiration date:


a. You owe $15.
b. You owe nothing.
c. Draw the payoff diagram:

You own a put option on Ford stock with a strike price of $10. The option will expire in exactly
six months’ time.
3.a. If the stock is trading at $8 in six months, what will be the payoff of the put?
3.b. If the stock is trading at $23 in six months, what will be the payoff of the put?
3.c. Draw a payoff diagram showing the value of the put at expiration as a function of
the stock price at expiration.

Long put value at expiration:


a. $2
b. $0
c. Draw a payoff diagram:
Assume that you have shorted the put with the above characteristics.
4.a. If the stock is trading at $8 in three months, what will you owe?
4.b. If the stock is trading at $23 in three months, what will you owe?
4.c. Draw a payoff diagram showing the amount you owe at expiration as a function
of the stock price at expiration.

Short put: value at expiration:


a. You owe $2.
b. You owe nothing.
c. Draw the payoff diagram:
Problem 2

Dynamic Energy Systems stock is currently trading for $33 per share. The stock pays no
dividends. A one-year European put option on Dynamic with a strike price of $35 is currently
trading for $2.10. If the risk-free interest rate is 10% per year, what is the price of a one-year
European call option on Dynamic with a strike price of $35?

Solution
Put-call parity:
K 35
C  P  S   2 .1 0  3 3   3 .2 8 2
1 r 1 .1

Problem 3

You happen to be checking the newspaper and notice an arbitrage opportunity. The current stock
price of Intrawest is $20 per share and the one-year risk-free interest rate is 8%. A one year put
on Intrawest with a strike price of $18 sells for $3.33, while the identical call sells for $7.
Explain what you must do to exploit this arbitrage opportunity.

Solution
The arbitrage opportunity exists because:
$18
$ 7  $ 3 .3 3  $ 2 0   $ 6 .6 6 .
1  0 .0 8 
So the call is overpriced compared to the portfolio of a put, the stock, and risk-free
borrowing.
As a result, the strategy would be to sell the call option, buy the put, buy the stock, and
borrow $16.67 (the present value of $18).
The net amount left after doing this is $.34, with no cash flows when the options expire.

Problem 4

Create the payoff profile of a butterfly spread by using only put options.

Solution
Long 1 put with K3. Short 2 puts with K2. Long 1 put with K1.
With K1 < K2 < K3.
Problem 5

Draw the payoff profile of the following portfolio: long position in the underlying asset, short
position in a call with strike price K2, long position in a put with strike price K1 where we have
K1 < K2. This payoff profile is typically called a collar. What are the incentives of the buyer of
such a portfolio?

Solution
Payoff profile: see correction in class.
Incentives: long position in underlying that you want to protect on the downside by
buying a put. Since buying a put can be interpreted as buying insurance, it is costly. The
investor can finance this cost by selling a call. Note that by doing so the investor gives up
some of the upside potential!

Problem 6

Wesley Corp. stock is trading for $25/share. Wesley has 20 million shares outstanding and a
market debt equity ratio of 0.5. Wesley’s debt is zero coupon debt with a 5-year maturity and a
yield to maturity of 10%.

a. Describe Wesley’s equity as a call option. What is the maturity of the call option?
What is the market value of the asset underlying this call option? What is the strike
price of this call option?
b. Describe Wesley’s debt using a call option.
c. Describe Wesley’s debt using a put option.

Solution
a. Maturity = 5 years
Assets = E + D = $25  20 + .5($25  20) = $500 + 250 = $750 million
Strike price = D = $250 million
b. Long the firm’s assets and short the equity call option above
c. Long risk-free debt and short a put option on Wesley’s assets with a 5-yr maturity and
$250 million face value

You might also like