Problem Set 8

Institution: Warwick Business School

Lecturer: Rory Mullen, Assistant Professor of Finance
Module: IB2660 Fundamentals of Finance
Term: Term 1, 2022
Due: Week 10 Seminar

Related Materials:

 Lectures:
Lecture 16: Options I
Lecture 17: Options II

 Readings:
Hillier et al. (2016, Chapters 22.1–22.8), Bodie et al. (2014, Chapters 20.1, 20.2, 20.4, and
21.1–21.3), Hull (2015, Chapters 10.1–10.5, 11.1–11.7, 13.1–13.6)

Questions marked * will be discussed in the Week 10 Seminar, time allowing. You should attempt
the marked questions before the seminar. We provide solutions to all questions after the seminar.

Theory

1.∗ The diagram below illustrates how the value C of a European call option with exercise price
X depends on the value S of the underlying asset, when there is still time remaining to expiry.
It also shows the payoff max(S

− X, 0) to the option at expiry and the lower arbitrage-based
bounds max S − P V (X), 0 to the value of the option. Assume that the underlying asset does
not pay a dividend during the remaining lifetime of the option.

(a) What happens to the lower bound and the graph of C vs. S as the option approaches
expiry? Why? What can you infer about how the value of a European call option varies
with changes in the riskless rate of interest?

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IB2660 Problem Set 8

Solution:

As the time to expiry approaches zero (T − t → 0),√the present value of the exercise
price P V (X) = Xe−r(T −t) → X and the volatility σ T − t → 0.
As P V (X) → X, the dashed kinked line representing the lower bound for the value of
the call option moves to the right.
√
As σ T − t → 0, the time value of the option, which exists whilst there is still time for
the value of the underlying asset to change, decays steadily, causing the option curve to
subside.
At expiry of the option, the option curve collapses onto the solid kinked line that
represents the payoff to the call option at expiry.
Similarly, if the risk-free rate decreases, P V (X) = Xe−r(T −t) again moves closer to X.
The lower bound for the value of the call option thus moves to the right. For a given
value S of the underlying asset, the value of the call option therefore decreases.
Another way of seeing this is as follows. The value of the call option tends to the lower
bound S − P V (X) as the option gets further in the money (i.e. as S increases).
This is because S − P V (X) represents the current value of the option if it is exercised
at expiry for sure. As S increases, the probability of exercising the option at expiry
increases and the option value tends to S − P V (X).

(b) What can you infer about early exercise of an American call option on an underlying asset
that does not pay a dividend during the remaining life of the option?

Solution: Since P V (X) < X, the lower bound S − P V (X) is strictly greater than the
payoff S − X if the call option is exercised. So a call option on an underlying asset that
does not pay a dividend during the lifetime of the option is always worth more “alive”
than “dead”. Hence, it is never optimal to exercise early an American call option on a
non-dividend-paying underlying asset.
Intuitively, there is no reason to acquire the underlying asset now by exercising the
option early because there is no dividend to collect that could offset the interest that is
forgone by paying the exercise price now rather than leaving the money in the bank
until the option expires.

(c) Draw an equivalent diagram to show how the value P of a European put with exercise price
X and its lower arbitrage-based bounds depend on the value S of the underlying asset,

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IB2660 Problem Set 8

when there is still time remaining to expiry. Assume that the underlying asset does not pay
a dividend during the remaining life of the option.

Solution:

(d) Is the value of such a European put option greater than or less than the payoff to the option
when the asset price, S, approaches zero and when there is a long time to expiry? What
can you infer about early exercise of an American put option on a non-dividend-paying
underlying asset?

Solution: The value of a European put option has a lower bound of P V (X) − S, which
is the dashed line that is kinked at S = P V (X). This lower bound equals the current
value of the put option if it were to be exercised at expiry for sure, so as S → 0, the
option value tends to the lower bound.
Since P V (X) < X, the lower bound and so also the European put curve can fall below
the solid line that represents the payoff X − S to the put option at expiry. Thus, the
value of a European put option can be less than its payoff or intrinsic value.
Because an American put option can be exercised early, its value can never be less than
its intrinsic value. Otherwise, there would be an arbitrage opportunity (see below).
There is a critical value S ∗ of the underlying asset below which it is always optimal to
exercise the American put option early.
If the value of the American put option were to fall below its intrinsic value, investors
could make a risk-free profit by simultaneously buying the put option for P , buying a
share in the underlying asset for S, and selling that share for X by exercising the put.
Such an arbitrage opportunity would quickly disappear as the market brought the price
P of the put option into line with the value S of the underlying asset.

2. The Black-Scholes formula for a European call option on a non-dividend-paying stock with
exercise price X and time to expiry T is

C = SN (d1 ) − P V (X)N (d2 )

where  
ln P VS(X) 1 √ √
d1 = √ + σ T; d2 = d1 − σ T .
σ T 2

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IB2660 Problem Set 8

(a) Use the Put-Call Parity relationship to derive the Black-Scholes formula for the value of a
European put option with the same exercise price and time to expiry.

Solution: From the Put-Call Parity relationship for European options with the same
exercise price and time to expiry written on non-dividend-paying stocks

PE = CE + P V (X) − S
= SN (d1 ) − P V (X)N (d2 ) + P V (X) − S



= P V (X) 1 − N (d2 ) − S 1 − N (d1 ) .

(b) What is the initial composition of the replicating portfolio for the European call option and
the corresponding European put option?

Solution: The replicating portfolio for an option is the portfolio of stocks and riskless
bonds (borrowing or lending at the risk-free rate) which replicates the option. It consists
of +∆ shares and an amount b in riskless bonds. For a European option, its initial
composition can be determined from the Black-Scholes formulae:

C = ∆C S + bC or P = ∆P S + bP .

For a European call, the replicating portfolio consists of ∆C = N (d1 ) > 0 in stock (i.e.
a long position in stock) and bC = −P V (K)N (d2 ) < 0 in riskless bonds (i.e. riskless
borrowing).


For a European put, the replicating portfolio consists of ∆P =
− 1 − N (d1 ) < 0 in
stock (i.e. a short position in stock) and bP = P V (K) 1 − N (d2 ) > 0 in riskless bonds
(i.e. riskless lending).

(c) Under what conditions will the European call and the European put be exercised? What is
the risk-neutral probability of exercise for each option?

Solution: European options can only be exercised at expiry. A European call will be
exercised only if ST ≥ X, whereas a European put will be exercised only if ST ≤ X.
The risk-neutral probability of a European call being exercised equals N (d2 ), whereas
the risk-neutral probability of a European put being exercised equals 1 − N (d2 ).
Convince yourself that the risk-neutral probabilities of the call being exercised or the
put being exercised must sum to 1. It can also be seen from the Black-Scholes formula
in (a) for the value of a European put.

(d) Now consider European call and put options on the same stock with the same time to
expiry but a lower exercise price. Is the “delta” of a European call option with exercise
price X greater than or less than the “delta” of the European call option with exercise price
X? Is the risk-neutral probability that the European call option with exercise price X will
be exercised greater than or less than the risk-neutral probability that the European call
option with exercise price X will be exercised?

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Solution: The lower the exercise price X, the greater is the delta ∆C = N (d1 ) of the
European call:
   
ln P V S(X 0 ) 1 √ ln S
P V (X) 1 √
X 0 < X ⇒ d01 = √ + σ T −t> √ + σ T − t = d1
σ T −t 2 σ T −t 2
0
⇒ N (d1 ) > N (d1 ) .

The greater is the risk-neutral probability N (d2 ) that the European call will be exercised
at expiry:
√ √
X 0 < X ⇒ d02 = d01 − σ T − t > d1 − σ T − t = d2 ⇒ N (d02 ) ≥ N (d2 ) .

This makes sense since the lower the exercise price X, the broader is the range of values
of the underlying asset ST ≥ X for which it is optimal to exercise the call at expiry.

(e) Repeat your analysis for European put options. Does the “delta” increase or decrease? Does
the risk-neutral probability of exercise increase or decrease if the option’s exercise price
decreases?

Solution: The lower the exercise price X, the greater is the delta ∆P of the European
put.
This result follows from Put-Call Parity P = P V (X) − S + C which (on differentiating
with respect to S) implies

∆P = ∆C − 1 = N (d1 ) − 1 .

Notice that European put option deltas satisfy −1 ≤ ∆P ≤ 0, because 0 ≤ N (d1 ) ≤ 1.

Also, the lower the value of X, the lower is the risk-neutral probability 1 − N (d2 ) that
the European put will be exercised at expiry. This makes sense since the range of values
of the underlying asset for which it is optimal to exercise the put at expiry is narrower,
the lower is the value of X.

Applications

3.∗ Suppose the current stock price of Scarman plc is £8.20, and the implied continuously compounded
risk-free rate for all maturities is 4%. Scarman plc is not intending to pay a dividend in the
foreseeable future. Options on Scarman plc are traded at the following prices:

Exercise Expiry Call price Put price

£8.00 3 months £0.26 -
£8.50 6 months £0.29 £0.38
£9.00 9 months - £0.58

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IB2660 Problem Set 8

(a) Assuming the options are European, check whether any bounds on individual option prices
or relationships between option prices (put-call parity) are violated by the option prices on
Scarman plc. If there are any violations, how would you exploit these to realise an arbitrage
profit?

Solution: We need to check the following bounds on the value of a European option:
0 ≤ C ≤ S and C ≥ S − P V (X),
0 ≤ P ≤ P V (X) and P ≥ P V (X) − S.

The upper and non-negative bounds on all options are satisfied by inspection. For the
other bounds:

Exercise Expiry C S − P V (X) Bound satisfied?

8.00 0.25 0.26 8.2 - 7.92 = 0.28 No
8.50 0.50 0.29 8.2 - 8.33 = -0.13 Yes

Exercise Expiry P P V (X) − S Bound satisfied?

8.50 0.50 0.38 8.33 - 8.2 = 0.13 Yes
9.00 0.75 0.58 8.73 - 8.2 = 0.53 Yes

To realize an arbitrage profit from the 3-month call option with X = 8.00, we have

Cash flows: Now In Three Months

ST < 8.00 ST ≥ 8.00
Long 3-month call option with X = 8.00: −0.26 0 ST − 8.00
Short the underlying asset: +8.20 −ST −ST
Lend P V (8.00) (long risk-free bonds): −7.92 +8.00 +8.00
Overall cash flows: +0.02 8.00 − ST ≥ 0 0

This arbitrage strategy realizes a cash inflow of £0.02 now, together with non-negative
payoffs in the future. Indeed, there is the added potential of a positive payoff at expiry
if the option expires out-of-the-money.

For put-call parity (“PCP”) to hold, we require:

P + S = C + P V (X).

Exercise Expiry P +S C + P V (X) PCP satisfied?

8.50 0.5 0.38 + 8.2 = 8.58 0.29 + 8.33 = 8.62 No

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IB2660 Problem Set 8

To take advantage of this arbitrage opportunity, go long the lower-priced portfolio (put
+ underlying asset) and go short the higher-priced portfolio (call + riskless bonds):

Cash flows: Now In Six Months

ST ≤ 8.50 ST ≥ 8.50
Long 6-month put, X = 8.50: −0.38 8.50 − ST 0
Long the underlying asset: −8.20 +ST +ST
Short 6-month call, X = 8.50: +0.29 0 −(ST − 8.50)
Borrow P V (8.50) (short riskless bond): +8.33 −8.50 −8.50
Overall cash flows: +0.04 0 0

This arbitrage strategy realizes a cash inflow of £0.04 now and has zero future exposure.
The riskless arbitrage profit equals £0.04.

(b) Do your answers change if the options are American? (You should just consider the bounds
on individual option prices)

Solution: If the options are American, the relevant bounds are:

0 ≤ C ≤ S and C ≥ S − P V (X),
0 ≤ P ≤ X and P ≥ X − S.

The bounds on the call options do not change. The upper bound on the put option is
satisfied by inspection. For the lower bound on the put option, consider the following:

Exercise Expiry P X −S Bound satisfied?

8.50 0.50 0.38 8.5 − 8.2 = 0.3 Yes
9.00 0.75 0.58 9.0 − 8.2 = 0.8 No

An arbitrage profit can be made by buying the 9-month put option with X = 9.00
and exercising it immediately, and simultaneously buying the underlying asset. Profit
= −0.58 + 9.0 − 8.2 = 0.22.

4. Assume that the market price of gold is $1,390/oz and the continuously-compounded risk-free
rate for all maturities is 1% per annum. European call and put options, each with a expiry of
one year and an exercise price of $1,400/oz are traded at $110/oz and $109/oz, respectively.
Ignore storage costs.
(a) i. Is there an arbitrage opportunity? If so, explain how you would trade to generate an
arbitrage profit. Calculate the arbitrage profit/oz.

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IB2660 Problem Set 8

Solution: Options should satisfy put-call parity P + S = C + P V (X):

P + S = 109 + 1390 = 1499

C + P V (X) = 110 + 1400e−0.01·1 = 1496,

so there is an arbitrage opportunity. Arbitrage profit = $1, 499/oz − $1, 496/oz =

$3/oz.

Cash flows now Cash flows at T

ST < X ST > X
Long call −110 0 ST − 1400
Long PV(X) riskless bonds −1386 +1400 +1400
Short put +109 ST − 1400 0
Short underlying asset +1390 −ST −ST
Total +3 0 0

Cash flows are zero in all future states. The immediate cash inflow of 3 therefore
represents an arbitrage profit.

ii. Calculate the no-arbitrage-based one-year forward price.

Solution:
F = S · erT = 1390e0.01 = $1, 404,
so the forward price is $1, 404/oz.

(b) Scarman Jewellery Ltd will require 100oz gold in one year and wishes to hedge its exposure
to gold price risk.
i. Explain how Scarman Jewellery Ltd can hedge its exposure using gold forward contracts.
If it uses forwards with forward price as in (a)(ii), what will Scarman Jewellery Ltd’s
overall cash flows be now and in one year’s time?

Solution: Scarman has a natural short position, so can go long a forward (or
futures) on 100oz gold with maturity 1 year. Cash flows are now zero to long
forward (or futures) position. Cash flows in 1 year’s time are given by
 
100 −ST + (ST − F ) = −100F = −$140, 400,

irrespective of the price of gold in one year.

ii. Suppose instead that Scarman Jewellery Ltd buys European call options and writes
European put options, both on 100oz of gold with exercise price $1,400/oz and expiry
one year. Based on the above market prices, what will Scarman Jewellery Ltd’s overall
cash flows be now and in one year’s time? Briefly explain the differences from your
answer in (i). Which should Scarman Jewellery Ltd prefer?

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IB2660 Problem Set 8

Solution: If Scarman buys European calls and writes European puts with X =
$1, 400/oz. Cash flows are now = 100(−110 + 109) = −$100. Cash flow in 1 year is
given by
 
100 −ST + max(ST − 1400, 0) − max(1400 − ST , 0) = −100 · 1400 = −$140, 000,

again irrespective of the price of gold in 1 year’s time.

So this is also a hedge. The differences from (i): pay $100 now, pay $400 less in 1
year. Scarman will prefer (ii) because the present value of cash flows from (ii) is
higher. Effectively, it is taking advantage of the mis-pricing of the options.

(c) A portfolio consisting of one long European call option and one long European put option,
both with the same exercise price and expiry date, is called a long straddle. Explain how
the value of a long straddle will change if
i. the volatility of returns on the underlying asset decreases, all else equal.

Solution: If volatility decreases, value of long call option decreases and value of
long put option decreases so value of long straddle decreases.

ii. the expected return on the underlying asset decreases, all else equal.

Solution: If the expected return on the underlying asset decreases, the value of the
straddle should not change because options are valued using a hedging/risk-neutral
valuation method and so do not depend on the expected return on the underlying
asset.

5. The current price of Warwick plc stock is £2.00. Over the next year, the price will either increase
by 25% or decrease by 20%. The riskless rate is 6% p.a., continuously compounded.
(a) For a one-year European call option on Warwick plc with exercise price £1.90, calculate
the option payoffs in each of the two states and its current hedge ratio or ‘delta’. Find
the composition of the hedging portfolio and use this to find the current value of the call
option.

Solution: From the question, u = 1.25 and d = 0.8. Express S and X in pence, and
consider the binomial trees below:

uS = 250 max(250 − 190, 0) = 60

S = 200 C

dS = 160 max(160 − 190, 0) = 0

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IB2660 Problem Set 8

The option’s hedge ratio or ∆ is given by

Cu − Cd 60 − 0 2
∆= = = .
uS − dS 250 − 160 3

The hedging portfolio consists of one long option and (−∆) shares, i.e. one long option
and short 2/3 shares. Its current value equals C − ∆S. In one year’s time, the portfolio
will have the same value in both possible future states:
2 2
Cu − ∆uS = 60 − 250 = −106
3 3
2 2
Cd − ∆dS = 0 − 160 = −106 .
3 3

It is equivalent to investing in risk-free bonds. Its current value is found by discounting

its future value at the risk-free rate:
 
−0.06·1 2
C − ∆S = e · −106 = −100.45
3
2
⇔ C = −100.45 + 200 = 32.88.
3
Hence, the value of the call option now is 32.88 pence.

(b) Suppose the market price of the call option in (a) is £0.30. Explain how you could, in
theory, make a risk-free arbitrage profit.

Solution: If the market price of the call option equals 30, the call option is undervalued.
Hence, we could make a risk-free arbitrage profit as follows:

Cash Flows
Today At Expiry
ST = uS = 250 ST = dS = 160
Buy call option: −30 +60 0
Sell 2/3 shares of stock: +133.33 −166.67 −160.67
Lend P V (106.67): −100.45 +106.67 +106.67
Total: +2.88 0 0

This strategy has no cash inflows or outflows in the future, but generates a cash inflow
of 2.88 today. This is the arbitrage profit.

(c) Find the risk-neutral probability that Warwick plc’s stock price will increase over the coming
year. Hence calculate the current value of a one-year European call option on Warwick plc
with exercise price £1.90 and check this gives the same answer as in (a).

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IB2660 Problem Set 8

Solution: Let δt = 1 denote the time step. The risk-neutral probabilities are:

erδt − d e0.06 − 0.8

π∗ = = = 0.5819, 1 − π ∗ = 0.4181.
u−d 1.25 − 0.8

To confirm, we can calculate

 
St+δt uS dS
E = π∗ + (1 − π ∗ )
St S S
= 0.5819 · 1.25 + 0.4181 · 0.8 = 1.0618
= e0.06 = erδt .

Using these risk-neutral probabilities, we can re-calculate the value of the option in (a):

C = e−rδt [π ∗ Cu + (1 − π ∗ )Cd ]
= e−0.06 [0.5819 · 60 + 0.4181 · 0]
= 32.8808.

(d) Use the put call parity relationship to deduce the current value of a one-year European put
option on Warwick plc with exercise price £1.90.

Solution: The put-call parity relationship for European options on the same underlying
asset with the same exercise price and the same expiry date is:

P + S = C + P V (X)
⇔ P + 200 = 32.8808 + 190e−0.06
⇔ P = 11.8161.

6.∗ Calculate the value of a European put option with exercise price £2.20 and two years to expiry.
The underlying asset pays no dividends and has current value £2.00. This value will either
increase by 25% or decrease by 20% over each of the next two years. The risk-free rate is 5%
p.a., continuously compounded. How does the value change if the put option is American?

Solution: Since u =1.25 and d = 0.8, the value of the underlying asset follows the binomial
process:

3.125
2.5
2 2
1.6
1.28

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IB2660 Problem Set 8

The risk-neutral probability π ∗ of an “up” jump equals:

erδt − d e0.05 − 0.8
π∗ = = 0.5584, 1 − π ∗ = 0.4416.
u−d 1.25 − 0.8
The time-step δt = 1 since we are using a two-period model to price a two-year option.

• Case 1: European Option

The value of a European put option with exercise price X = 2.20 is obtained by working
backwards through the binomial tree, starting from the payoff = max(X − S, 0) at
expiry. At each node, the value of the European put option is calculated as the
discounted expected future value, using risk-neutral probabilities to calculate expected
values and the risk-free rate as the discount rate:

max(2.2 − 3.125, 0) = 0
0.0840
0.2516 max(2.2 − 2, 0) = 0.2
0.4927
max(2.2 − 1.28, 0) = 0.92

Here, we have
Pu = e−0.05 [0.5584 · 0 + 0.4416 · 0.2] = 0.0840
Pd = e−0.05 [0.5584 · 0.2 + 0.4416 · 0.92] = 0.4927
P = e−0.05 [0.5584 · 0.0840 + 0.4416 · 0.4927] = 0.2516.

• Case 2: American Option

Now the option can be exercised early at either t = 0 or t = 1. The option holder
will exercise early if an only if the option is worth more “dead” than “alive” i.e. the
payoff from early exercise at that node in the binomial tree is greater than the value
we calculated for the European option. If the option is exercised early at t = 1, the
payoff at each node in the tree will be:
Up State: max(0, X − Su ) = max(0, 2.2 − 2.5) = 0 (no early exercise)
Down State: max(0, X − Sd ) = max(0, 2.2 − 1.6) = 0.6 (early exercise).

The value of the American put at t = 1 at each of these two nodes is then:
Up State: Pu = max(0.0840, 0) = 0.0840 (no early exercise)
Down State: Pd = max(0.4927, 0.6) = 0.6 (early exercise).

To value the American put at t = 0, we first calculate:

 
P V expected value
of put at t=1 = e−rδt [π ∗ Pu + (1 − π ∗ Pd )]
= e−0.05 [0.5584 · 0.0840 + 0.4416 · 0.6]
= 0.2967.

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IB2660 Problem Set 8

We then compare this value with the payoff from exercising the put early at t = 0:

max(0, X − S) = max(0, 2.2 − 2.0) = 0.2,

and take the greater of the two to obtain the value of the American put at t = 0:

P = max(0.2967, 0.2) = 0.2967 (no early exercise at t = 0).

Note that the value (= 0.2967) at t = 0 of the American put is greater than the corresponding
value (= 0.2561) of the European put. This is because early exercise of the American put is
optimal in the down state at t = 1.

7. Suppose stock in Leamington plc has a current price of 3.24 and annualized volatility of returns
30%. Assume that the continuously-compounded risk-free rate is 6% p.a.
(a) Use the Normal distribution tables to calculate the value C and “delta” of a 6-month
European call on Leamington plc stock, with exercise price X = 3.00.

Solution: The value of a European call option is given by the Black-Scholes formula:

C = SN (d1 ) − P V (X)N (d2 )

where  
S
ln P V (X) 1 √ √
d1 = √ + σ T − t, d2 = d1 − σ T − t.
σ T −t 2

Here S = 324, X = 300, σ = 0.30, r = 0.06 and T − t = 0.5, where S and X are now
written in pence. Now value the option in four steps:

Step 1: Calculate the present value of the exercise price X:

P V (X) = Xe−r(T −t) = 300e−0.06·0.5 = 291.1337.

√
Step 2: Calculate the moneyness ratio S/P V (X) and the volatility σ T − t of the
underlying asset over the remaining lifetime of the option:
S 324
= = 1.1129
P V (X) 291.1337
√ √
σ T − t = 0.30 · 0.5 = 0.2121

Step 3: Calculate d1 , d2 :
ln 1.1129 1
d1 = + 0.2121 = 0.6103
0.2121 2
d2 = 0.6103 − 0.2121 = 0.3982.

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IB2660 Problem Set 8

Step 4: Use the cumulative Normal distribution tables and linear interpolation to
obtain the risk-neutral probabilities N (d1 ), N (d2 ):
 
0.6103 − 0.61  
N (d1 ) = N (0.61) + N (0.62) − N (0.61) = 0.7292
0.62 − 0.61
 
0.3982 − 0.39  
N (d2 ) = N (0.39) + N (0.40) − N (0.39) = 0.6547.
0.40 − 0.39

Substituting the results from the above four steps into the Black-Scholes formula, we
have for the value of the call option

C = 324 · 0.7292 − 291.13 · 0.6547

= 45.63.

The delta of the call option is ∆C = N (d1 ) = 0.7292.

(b) Use the “delta” calculated in (a) to estimate the change in price of the call option if
Leamington plc’s stock price
i. increases by 5p.

Solution: For small changes δS in the underlying asset price, the approximate
change in value of the call option is δC ≈ ∆C δS.
For δS = 5,
δC ≈ ∆C δS = N (d1 ) · 5 = 0.7292 · 5 = 3.65,
i.e. the call price would increase by approximately 3.65p.

ii. decreases by 5p.

Solution: For δS = −5,

δC ≈ N (d1 )(−5) = 0.7292(−5) = −3.65,

i.e. the call price would decrease by approximately 3.65p.

(c) Use the Black-Scholes formula to calculate the actual value of the call option if the stock
price increases or decreases by 5p and comment on your results. Is the actual change in
price larger or smaller than your estimate in (b)? How is that related to the shape of the
graph of a call option as a function of the underlying asset price?

Solution: Using the Black-Scholes formula with S = 329 and all other parameters as
in (a):
S 329
= = 1.1301
P V (X) 291.1337
d1 = 0.6825, d2 = 0.4703

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IB2660 Problem Set 8

N (d1 ) = 0.7525, N (d2 ) = 0.6809.

The new value of the call option is:

C = 329 · 0.7525 − 291.1337 · 0.6809 = 49.34.

Hence δC = 49.34 − 45.63 = 3.7. Using the Black-Scholes formula with S = 3.19 and
all other parameters as in (a),

S 319
= = 1.0957
P V (X) 291.1337
d1 = 0.5370, d2 = 0.3248
N (d1 ) = 0.7044, N (d2 ) = 0.6273.

The new value of the call option is:

C = 319 · 0.7044 − 291.1337 · 0.6273 = 42.08.

Hence δC = 42.08 − 45.63 = −3.55, and the approximation δC ≈ ∆C δS is a reasonably

good one.
However, it slightly understates the increase in the value of the call option if the value
of the underlying asset increases. Likewise, it slightly overstates the decrease in the
value of the call option if the value of the underlying asset decreases.
This is due to the positive curvature of the option value with respect to the value of the
underlying asset i.e. the graph of the call option value vs. the underlying asset value
always lies above the straight line, with slope ∆, that is tangent to the graph.

(d) Use the put-call parity relationship for European options to deduce the “delta” of the
corresponding European put option on Leamington plc stock (with the same exercise price
and expiry date).

Solution: The put-call parity relationship for European options relates the values of
European call and put options on the same underlying asset with the same exercise
price and the same expiry date:

P + S = C + P V (X).

Differentiating both sides of this equation with respect to S,

∂P ∂C
+1= +0
∂S ∂S
∆P + 1 = ∆C .

Hence ∆P = ∆C − 1 = 0.7292 − 1 = −0.2708.

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IB2660 Problem Set 8

References
Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments (10th). McGraw Hill.
Hillier, D., Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2016). Corporate finance (3rd European
Edition). McGraw Hill.
Hull, J. C. (2015). Options, futures, and other derivatives (9th). Pearson Education.

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