NUGSB MSF Investments II Problem Set 3: Options Deadline: Friday

February 16, 2024, 23:59

Question 1 and 2 will make use of the below table. You should assume that today is January 02, 2008, the
yield curve is flat at 4% per annum for maturities up to one year, and IBM pays a cash dividend of $0.40 on
March 10, 2008, and $0.50 on June 10, 2008, in line with expectations.

1. Compute the largest potential loss (or the worst case scenario) for a buyer of a naked call option C Jul
IBM 08 100.

2. Draw one diagram with the combined payoff at expiration that results from a position that consists of
buying one P IBM Jan 08 90, writing one P IBM Jan 08 95, writing one C IBM Jan 08 100 and buying one C IBM
Jan 08 105.

3. The pay-off to a ‘protective put’ option strategy can be described, using S for the price of the
underlier and X for the strike price, as
(A) Max(S, X) (B) Min(S, X) (C) Max(S-X, X-S) (D) Min(S-X, X-S)
4. Which of the following four option strategies is most similar to a ‘condor’?
(A) bear spread (B) bull spread (C) butterfly spread (D) straddle

5. A stock has shown large up and down swings in the past weeks after reporting an unexpected and
unexplained cost item in the latest quarterly earnings report. You expect the CFO to issue an press release
soon that will calm down the market and that the stock will be trading in a narrow trading range for months
after that press release. The following option strategy would take advantage of this view:
(A) collar (B) bear spread (C) long strangle (D) short straddle

6. For the Cox, Ross and Rubinstein (1979) binomial tree model, calculate the values of the model
parameters u, d, and p to value an option on a foreign currency. The tree step size is 1 month; the domestic
(continuously compounded) interest rate is 5% per annum; the foreign (continuously compounded)
interest rate is 8% per annum; the volatility is 12% per annum.
(i) u =

(ii) d =

(iii) p =

7. Consider a one-period binomial model. A stock is currently trading at $60 and there is a probability of
4/7 that the price goes up to $100 and a probability of 3/7 that the price goes down to $30 over the
course of the next six months. A 6-month Treasury bill trades at $95. Compute the value of an at-the-
money straddle on the stock with 6-months to maturity.

8. Consider a European call option on a stock. The current stock price is $50. The time to expiration is 15
months; the strike price is $55. The future stock price follows a lognormal distribution. Volatility is 25%
per annum. The risk-free interest is 8% per annum (continuously compounded). Dividends of $1.50 are
expected in 4 months and 10 month from now. Calculate the price of the option.

9. The oil futures price is currently $70; its volatility is 20% per annum; the risk-free interest rate is 6%
per annum; estimated storage costs are 5% per annum; estimated convenience yield is 6% per annum.
All rates are based on continuous compounding. What is the value of a five-month European put on
the futures with a strike price of $65?

10. Compute the gamma of a short position in a six-month straddle on the SPX index with a strike of 3000
if the index has a current value of 2980, a continuously compounded annualized dividend yield of 2%
and an annualized standard deviation of return of 20%. The annualized continuously compounded six-
month interest rate is 4% per annum. Clearly indicate the sign (+/-) of the gamma and use four decimal
places.

11. An exchange rate is currently 1.0 and the implied volatilities of 60-month European options with strikes
0.7, 0.8, 0.9, 1, 1.1, 1.2, 1.3 are 13%, 12%, 11%, 10%, 11%, 12% 13%. The domestic and foreign riskfree
rates are both 2.5%. Calculate implied probability distribution and compare it with the implied
distribution where all the implied volatilities are 11.5%. (Hint: Look at Example 19A.1 and the appendix
of Chapter 19.)
12. Consider a 1-year European call option on a stock when the stock price is $30, the strike price is $30,
the risk-free rate is 5%, and the volatility is 25% per annum. Calculate the price, delta, gamma, vega,
theta, and rho of the option. Verify that delta is correct by changing the stock price to $30.1 and
recomputing the option price. Verify that gamma is correct by recomputing the delta for the situation
where the stock price is $30.1. Carry out similar calculations to verify that vega, theta, and rho are
correct. Plot the option price, delta, gamma, vega, theta, and rho against the stock price for the stock
option.

13. It is February 4. July call options on corn futures with strike prices of 260, 270, 280, 290, and 300 cost
26.75, 21.25, 17.25, 14.00, and 11.375, respectively. July put options with these strike prices cost 8.50,
13.50, 19.00, 25.625, and 32.625, respectively. The options mature on June 19, the current July corn
futures price is 278.25, and the riskfree interest rate is 1.1%. Calculate implied volatilities for the
options. Comment on the results you get.

14. Consider an American call option when the stock price is $18, the exercise price is $20, the time to
maturity is 6 months, the volatility is 30% per annum, and the risk-free interest rate is 10% per annum.
Two equal dividends are expected during the life of the option with ex-dividend dates at the end of 2
months and 5 months. Assume the dividends are 40 cents. Use Black’s approximation and the to value
the option. How high can the dividends be without the American option being worth more than the
corresponding European option?

15. A stock index currently stands at 300 and has a volatility of 20%. The risk-free interest rate is 8% and
the dividend yield on the index is 3%. Use a three-step binomial tree to value a six-month put option
on the index with a strike price of 300 if it is (a) European and (b) American?

16. Consider a European call and a European put with the same strike price and time to maturity. Show
that they change in value by the same amount when volatility increases from a level σ1 to a new level
σ2 within a short period of time.

17. The current futures prices for delivery of soybeans in 5 months from now is $525. The risk-free interest
rate is 6% per annum. A European put option of soybean futures with a strike of 525 and 5 month to
maturity has an option premium of $20. Calculate the implied volatility of soybeans futures prices.
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