Prob Set - 1 - Solution
Prob Set - 1 - Solution
Compute the payoff and profit to a call buyer, a call writer, put buyer and put writer if the strike
(exercise) price for both the put and the call is $45, the stock price is $50, the call premium is $3.50 and
the put premium is $2.50.
2. Compute the payoff to the long and short positions in a forward contract given that the forward price is
$25 and the spot price at maturity is $30.
First, the long position payoff:
payoff = ST − K
= $30 − $25
= $5
Second, the short position payoff:
payoff = −(ST − K)
= −($30 − $25)
= −$5
3. Suppose that a company based in the United States will receive a payment of €10000000 in three
months. The company is worried that the euro will deprecate and is contemplating using a forward
contract to hedge the risk. Compute the following:
a. The value of the €10000000 in U.S dollars at maturity given that the company hedges the exchange
rate risk with a forward contract at 1.25 $/€.
b. The value of the €10000000 in U.S dollars at maturity given that the company did not hedge the
exchange rate risk and the spot rate at maturity is 1.20 $/€.
a. The value at maturity for the hedged position:
= €10000000 × 1.25 $/€ = $12500000
Is it a short or long hedge? Because the company worried that the euro will deprecate at the time of
the payment receipt, the company engage in short hedge to eliminate exchange rate risk by selling
€10000000 in the 3-month forward market at an exchange rate of 1.25 $/€. This would have the
effect of locking in the US dollars to be realized for the euro at $12500000
With the benefit of the hindsight, the hedging decision was successful. But why? Because they ended up
getting more dollars for Euros i.e., the exchange rate they locked in turned up to higher than the spot at
maturity.
As we discussed, hedgers use forward contract to lock in the price of the underlying. Thus, hedgers give
up any favorable price movements that may be realized if the exposure was unhedged. In our case the
price moved according to the expectation of the company.
4. Suppose that an investor owns one share of ABC stock currently prices at $30. The investor is worried
about the possibility of a drop in share price over the next three months and is contemplating purchasing
put options to hedge this risk. Compute the following:
a. The profits on the unhedged position if the stock price in three months is $25.
b. The profits on the unhedged position if the stock price in three months is $35.
c. The profits for a hedged stock position if the stock price in three months is $25, the strike price on
the put is $30, and the premium is $1.5.
d. The profits for a hedged stock position if the stock price in three months is $35, the strike price on
the put is $30, and the premium is $1.5.
a. profit = ST − S0
= $25 − $30
= −$5
b. profit = ST − S0
= $35 − $30
= $5
5. An investor believes that the euro will strengthen against the dollar over the next three months and
would like to take a position with a value of €250000. He could purchase euros in the spot market at
0.80 $/€ or purchase two futures contracts at 0.83 $/€ with an initial margin of $10000. Compute the
profit from the following:
a. Purchasing euros in the spot market if the spot rate in three months is 0.85 $/€.
b. Purchasing euros in the spot market if the spot rate in three months is 0.75 $/€.
c. Purchasing the future contract if the spot rate in three months is 0.85 $/€.
d. Purchasing the future contract if the spot rate in three months is 0.75 $/€.
The limited amount of initial investment creates significant leverage. Futures contract results in either large
gains or losses. This is evident from the resultant ROI in the case of the futures-based strategy compared to its
spot market counterpart. Also, these gains and losses are symmetric.
6. An investor who has $30000 to invest believes that the price of stock XYZ will increase over the next
three months. The current price of the stock is $30. The investor could directly invest in the stock, or she
could purchase 3-month call options with a strike price of $35 for $3. Compute the profit from the
following:
a. Investing directly in the stock if the price of the stock is $45 in three months.
b. Investing directly in the stock if the price of the stock is $25 in three months.
c. Purchasing call options if the price of the stock is $45 in three months.
d. Purchasing call options if the price of the stock is $25 in three months.
c. First, we need to calculate the number of call options to be purchased Given by $30000/$3=10000
profit = position size × [Max(0, ST – X) − c0 ]
= 10000 × [Max(0, $45 – $35) − $3]
= 10000 × [Max(0, $10) − $3]
= 10000 × [10 − $3]
= 10000 × [$7]
= $70000
d. profit = position size × [Max(0, ST – X) − c0 ]
= 10000 × [Max(0, $25 – $35) − $3]
= 10000 × [Max(0, − $10) − $3]
= 10000 × [0 − $3]
= 10000 × [−$3]
= −$30000
Option like futures creates significant leverage as the investor need only to pay the option’s premium to
purchase the option. However, options fifer from futures in that options have asymmetrical payoffs. For long
call position (our case) gains can be very large while losses are limited to the option premium.
7. Assume stock DEF trades on the New York Stock Exchange (NYSE) and the Tokyo Stock Exchange
(TSE). The stock currently trades on the NYSE for $32 and on the TSE for ¥2880. Given the current
exchange rate is 0.0105 $/¥, determine if an arbitrage profit is possible.
This example is very simplistic. However, it will help you understand the arbitrage concept. To determine
whether the law of one price holds or not, we need to convert price into dollars.
𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 $ = ¥2880 × 0.0105 $/¥
= $30.24
So, one buys the stock DEF on TSE and sell it on the NYSE. The profit is the difference between the price on
the NYSE and TSE i.e., $1.76
8. Options and futures are zero-sum games what do you think is meant by this statement?
10. What is the difference between entering into a long forward contract when the forward price is $50 and
taking a long position in a call option to buy the asset for $50 (strike price)?
11. When first issued, a stock provides funds for a company. Is the same true for a stock option?