RMSC2001 Assignment 4

Deadline 18 Nov 2022

Question 1
We consider a European call and a European put option on an underlying asset
with the same strike price 𝐾𝐾 and maturity 𝑇𝑇. Let 𝑆𝑆𝑡𝑡 be the price of a unit of the
underlying asset at time 𝑡𝑡 and 𝑟𝑟 be the risk-free interest rate. 𝑡𝑡 = 0 is
considered the current time.
(a) By considering the following portfolios, show that
𝑐𝑐𝐸𝐸 (𝑡𝑡) ≥ max�𝑆𝑆𝑡𝑡 − 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) , 0�,
where 𝑐𝑐𝐸𝐸 (𝑡𝑡) is the price of the European call at time 𝑡𝑡.
A: Hold one European call and 𝐾𝐾 units of zero-coupon bonds
B: One unit of the underlying asset
(b) By considering the following portfolios, show that
𝑝𝑝𝐸𝐸 (𝑡𝑡) ≥ max�𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) − 𝑆𝑆𝑡𝑡 , 0�,
where 𝑝𝑝𝐸𝐸 (𝑡𝑡) is the price of the European put at time 𝑡𝑡.
A: Hold one European put and one unit of the underlying asset
B: 𝐾𝐾 units of zero-coupon bonds
(c) If 𝑆𝑆0 = $20, 𝐾𝐾 = $18, 𝑟𝑟 = 10%, 𝑇𝑇 = 1 year, what should an arbitrageur
do if the European call costs $3?
(d) If 𝑆𝑆0 = $37, 𝐾𝐾 = $40, 𝑟𝑟 = 5%, 𝑇𝑇 = 0.5 year, what should an arbitrageur
do if the European put costs $1?
Answer.
(a) On the maturity date, value of portfolio A is always larger than that of
portfolio B.

Portfolio Case 1: 𝑆𝑆𝑇𝑇 > 𝐾𝐾 Case 2: 𝑆𝑆𝑇𝑇 ≤ 𝐾𝐾

A 𝑆𝑆𝑇𝑇 𝐾𝐾

B 𝑆𝑆𝑇𝑇 𝑆𝑆𝑇𝑇
 Then, we know that value of portfolio A is always larger than that of
portfolio B at any time before maturity. Otherwise, arbitrage opportunity
can be constructed by selling portfolio B and purchasing portfolio A.
Hence,
𝐶𝐶𝐸𝐸 (𝑡𝑡) + 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) ≥ 𝑆𝑆𝑡𝑡
⟹ 𝐶𝐶𝐸𝐸 (𝑡𝑡) ≥ 𝑆𝑆𝑡𝑡 − 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡)
Option premium must be a positive amount of cash since the right is
solely given to the holder. Thus, 𝐶𝐶𝐸𝐸 (𝑡𝑡) ≥ 0.
Consequently, 𝐶𝐶𝐸𝐸 (𝑡𝑡) ≥ max�𝑆𝑆𝑡𝑡 − 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) , 0�.
(b) On the maturity date, value of portfolio A is always larger than that of
portfolio B.

Portfolio Case 1: 𝑆𝑆𝑇𝑇 > 𝐾𝐾 Case 2: 𝑆𝑆𝑇𝑇 ≤ 𝐾𝐾

A 𝑆𝑆𝑇𝑇 𝐾𝐾

B 𝐾𝐾 𝐾𝐾

Then, we know that value of portfolio A is always larger than that of

portfolio B at any time before maturity. Otherwise, arbitrage opportunity
can be constructed by selling portfolio B and purchasing portfolio A.
Hence,
𝑝𝑝𝐸𝐸 (𝑡𝑡) + 𝑆𝑆𝑡𝑡 ≥ 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡)
⟹ 𝑝𝑝𝐸𝐸 (𝑡𝑡) ≥ 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) − 𝑆𝑆𝑡𝑡
Option premium must be a positive amount of cash since the right is
solely given to the holder. Thus, 𝑝𝑝𝐸𝐸 (𝑡𝑡) ≥ 0.
Consequently, 𝑝𝑝𝐸𝐸 (𝑡𝑡) ≥ max�𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) − 𝑆𝑆𝑡𝑡 , 0�.
(c) At 𝑡𝑡 = 0
Action now Cash flow
Buy the call option −3
short sell 𝑆𝑆 20
risk free investment −17
 Action at maturity (𝑆𝑆1 > 18) Cash flow
Option is exercised to acquire a stock at $18 𝑆𝑆1 − 18
A stock is acquired to settle the short selling −𝑆𝑆1
17 × 1.1
risk free investment
= 18.79
Net cash flow 0.79
Action at maturity (𝑆𝑆1 < 18) Cash flow
Option is not exercised 0
A stock is acquired to settle the short selling −𝑆𝑆1
risk free investment 17 × 1.1 = 18.79
Net cash flow 18.79 − 𝑆𝑆1 > 0

(d) At 𝑡𝑡 = 0
Action now Cash flow
Buy the put option −1
Buy 𝑆𝑆 −37
Borrow at 5% 38

Action at maturity (𝑆𝑆0.5 < 40) Cash flow

Option is exercised to sell the stock at $40 40 − 𝑆𝑆0.5
The acquired stock 𝑆𝑆0.5
0.05
Repaid the debt −38 × �1 + � = −38.95
2
Net cash flow 1.05

Action at maturity (𝑆𝑆0.5 > 40) Cash flow

Option is not exercised 0
The acquired stock 𝑆𝑆0.5
Repaid the debt −38.95
Net cash flow 𝑆𝑆0.5 − 38.95 > 0
Question 2.
Consider a portfolio consisting of a forward contract on an asset and a European
put option on the asset with the same maturity as the forward contract and a
strike price that is equal to the forward price of the asset at the time the
portfolio is set up. Show that the European put option has the same value as a
European call option with the same strike price and maturity.
Answer.
The payoff of the forward contract at maturity is 𝑆𝑆𝑇𝑇 − 𝐹𝐹0 , where 𝑆𝑆𝑇𝑇 is the price
of the asset at maturity and 𝐹𝐹0 is the forward price of the asset at the time the
portfolio is set up. Note that the delivery price in the forward contract is also 𝐹𝐹0 .
The payoff of the put option at maturity is max(𝐹𝐹0 − 𝑆𝑆𝑇𝑇 , 0). Hence, the payoff
of the portfolio at maturity is 𝑆𝑆𝑇𝑇 − 𝐹𝐹0 + max(𝐹𝐹0 − 𝑆𝑆𝑇𝑇 , 0) = max(0, 𝑆𝑆𝑇𝑇 − 𝐹𝐹0 ).
This is the same payoff as that of a European call option with the same maturity
as the forward contract and an exercise price equal to 𝐹𝐹0 .
We have shown that the forward contract plus the put is worth the same as a
call with the same strike price and time to maturity as the put.
Since the forward contract is worth zero at the time the portfolio is set up, the
put is worth the same as the call at the time the portfolio is set up.
Question 3.
A trader buys a call option with a strike price of $45 and a put option with a
strike price of $40. Both options have the same maturity. The call costs $3 and
the put costs $4. Draw a diagram showing the variation of the trader’s profit
with the asset price.
Answer.
Let 𝑆𝑆𝑇𝑇 be the price of the underlying asset at maturity of the options.
(a) When 𝑆𝑆𝑇𝑇 ≤ 40, the put option provides a payoff of 40 − 𝑆𝑆𝑇𝑇 and the call
option provides no payoff. The options cost $7 and so the total profit is
33 − 𝑆𝑆𝑇𝑇 .
(b) When 40 < 𝑆𝑆𝑇𝑇 < 45, neither option provides a payoff. There is a net loss
of $7.
(c) When 𝑆𝑆𝑇𝑇 ≥ 45, the call option provides a payoff of 𝑆𝑆𝑇𝑇 − 45 and the put
option provides no payoff. The total profit is 𝑆𝑆𝑇𝑇 − 45 − 7 = 𝑆𝑆𝑇𝑇 − 52.
The trader makes a profit (ignoring the time value of money) if the stock price is
less than $33 or greater than $52. We call the trading strategy a strangle.

15

10

0 𝑆𝑆𝑇𝑇
20 30 40 50 60
-5

-10

Question 4 (Difficult Question, Optional)

Let 𝑐𝑐𝑡𝑡 (𝐾𝐾) be the price of a European call option with strike 𝐾𝐾 at time 𝑡𝑡. Let
𝐶𝐶𝑡𝑡 (𝐾𝐾) be the price of an American call option with strike 𝐾𝐾 at time 𝑡𝑡. The time
to maturity is at 𝑡𝑡 = 𝑇𝑇, the risk-free annually compounded interest rate is 𝑟𝑟. The
underlying security pays no dividends.
(a) Use a no-arbitrage argument to prove that 𝑐𝑐0 (𝐾𝐾) = 𝐶𝐶0 (𝐾𝐾).
(Hint: Consider two cases: when the American option does not exercise
early and when the American option is exercised at time 𝜏𝜏 ∈ (0, 𝑇𝑇))
(b) Comparing the payoffs of the following two portfolios, show that
𝑐𝑐𝑡𝑡 (𝐾𝐾) + 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) = 𝑝𝑝𝑡𝑡 (𝐾𝐾) + 𝑆𝑆𝑡𝑡 ,
where 𝑝𝑝𝑡𝑡 (𝐾𝐾) is the price of a European put option with strike 𝐾𝐾 at time 𝑡𝑡.
The time to maturity is at 𝑡𝑡 = 𝑇𝑇.
A: hold a call and 𝐾𝐾 units of zero-coupon bond
C: hold a put and one unit of stock
(c) Use the result of (a) and (b), show that
𝐶𝐶𝑡𝑡 (𝐾𝐾) − 𝑃𝑃𝑡𝑡 (𝐾𝐾) ≤ 𝑆𝑆𝑡𝑡 − 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) ,
where 𝑃𝑃𝑡𝑡 (𝐾𝐾) is the price of an American put option with strike 𝐾𝐾 at time
𝑡𝑡. The time to maturity is at 𝑡𝑡 = 𝑇𝑇.
(d) Comparing the following two portfolios, show that
𝐶𝐶𝑡𝑡 (𝐾𝐾) − 𝑃𝑃𝑡𝑡 (𝐾𝐾) ≥ 𝑆𝑆𝑡𝑡 − 𝐾𝐾.
E: A European call plus 𝐾𝐾 dollar cash
F: An American put plus one unit of stock
Both options share the same strike and maturity.
(Hint: Consider two cases: when the American option does not exercise
early and when the American option is exercised at time 𝜏𝜏 ∈ (0, 𝑇𝑇))
(e) The price of an American call on a non-dividend-paying stock is $4. The
stock price is $31, the strike price is $30, and the expiration date is in three
months. The risk-free interest rate is 8%. Derive upper and lower bounds
for the price of an American put on the same stock with the same strike
price and expiration date.
Answer.
(a) When 𝐶𝐶0 (𝐾𝐾) > 𝑐𝑐0 (𝐾𝐾), we consider the following actions.
Action at time 𝑡𝑡 Cash flow
Buy an European call −𝑐𝑐0 (𝐾𝐾)
Sell an American call 𝐶𝐶0 (𝐾𝐾)
Invest risk-free −�𝐶𝐶0 (𝐾𝐾) − 𝑐𝑐0 (𝐾𝐾)�

When the American option does not exercise early,

Action at maturity Cash flow
Payoff of the European call max(𝑆𝑆𝑇𝑇 − 𝐾𝐾, 0)
Payoff of the American call − max(𝑆𝑆𝑇𝑇 − 𝐾𝐾, 0)
Risk-free investment �𝐶𝐶0 (𝐾𝐾) − 𝑐𝑐0 (𝐾𝐾)�(1 + 𝑟𝑟)𝑇𝑇
Net cash flow �𝐶𝐶0 (𝐾𝐾) − 𝑐𝑐0 (𝐾𝐾)�(1 + 𝑟𝑟)𝑇𝑇 > 0

When the American option is exercised at time 𝜏𝜏 ∈ (0, 𝑇𝑇)

Action at maturity Cash flow
Payoff of the European call 𝑐𝑐𝜏𝜏 (𝐾𝐾)
Payoff of the American call − max(𝑆𝑆𝜏𝜏 − 𝐾𝐾, 0)
Risk-free investment �𝐶𝐶0 (𝐾𝐾) − 𝑐𝑐0 (𝐾𝐾)�(1 + 𝑟𝑟)𝜏𝜏
𝑐𝑐𝜏𝜏 (𝐾𝐾) − max(𝑆𝑆𝜏𝜏 − 𝐾𝐾, 0)
Net cash flow
+ �𝐶𝐶0 (𝐾𝐾) − 𝑐𝑐0 (𝐾𝐾)�(1 + 𝑟𝑟)𝜏𝜏 > 0
 Since 𝑐𝑐𝑡𝑡 (𝐾𝐾) ≥ 𝑆𝑆𝑡𝑡 − 𝐾𝐾(1 + 𝑟𝑟)−𝜏𝜏 ≥ 𝑆𝑆𝜏𝜏 − 𝐾𝐾 and the call option would only
be exercised when 𝑆𝑆𝜏𝜏 ≥ 𝐾𝐾,
𝑐𝑐𝜏𝜏 (𝐾𝐾) − max(𝑆𝑆𝜏𝜏 − 𝐾𝐾, 0) + �𝐶𝐶0 (𝐾𝐾) − 𝑐𝑐0 (𝐾𝐾)�(1 + 𝑟𝑟)𝜏𝜏 > 0.
Since the net cash flows from both scenarios are positive, we have an
arbitrage opportunity. With no arbitrage, 𝐶𝐶0 (𝐾𝐾) ≤ 𝑐𝑐0 (𝐾𝐾). Since 𝐶𝐶0 (𝐾𝐾) ≮
𝑐𝑐0 (𝐾𝐾), we must have 𝐶𝐶0 (𝐾𝐾) = 𝑐𝑐0 (𝐾𝐾).
(b) On the maturity date, the two portfolios share the same value.

Portfolio Case 1: 𝑆𝑆𝑇𝑇 > 𝐾𝐾 Case 2: 𝑆𝑆𝑇𝑇 ≤ 𝐾𝐾

A 𝑆𝑆𝑇𝑇 𝐾𝐾
C 𝑆𝑆𝑇𝑇 𝐾𝐾

Again, at any time before 𝑡𝑡 ≤ 𝑇𝑇, values of portfolio A and C must be the
same to eliminate arbitrage opportunities. Thus, we get the parity.
(c) Using 𝐶𝐶𝑡𝑡 (𝐾𝐾) = 𝑐𝑐𝑡𝑡 (𝐾𝐾), we can get
𝑃𝑃𝑡𝑡 (𝐾𝐾) ≥ 𝑝𝑝𝑡𝑡 (𝐾𝐾)
= 𝑐𝑐𝑡𝑡 (𝐾𝐾) + 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) − 𝑆𝑆𝑡𝑡
= 𝐶𝐶𝑡𝑡 (𝐾𝐾) + 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡) − 𝑆𝑆𝑡𝑡
or
𝐶𝐶𝑡𝑡 (𝐾𝐾) − 𝑃𝑃𝑡𝑡 (𝐾𝐾) ≤ 𝑆𝑆𝑡𝑡 − 𝐾𝐾𝑒𝑒 −𝑟𝑟(𝑇𝑇−𝑡𝑡)
(d) We consider the portfolio values under two cases.
Case 1: The put option is not exercised pre-maturely.
At time 𝑇𝑇, portfolio F is worth
max(𝑆𝑆𝑇𝑇 , 𝐾𝐾),
and portfolio E is worth
max(𝑆𝑆𝑇𝑇 , 𝐾𝐾) + 𝐾𝐾𝑒𝑒 𝑟𝑟(𝑇𝑇−𝑡𝑡) − 𝐾𝐾 ≥ max(𝑆𝑆𝑇𝑇 , 𝐾𝐾).
Portfolio E is worth more than portfolio F.
Case 2: The put option is exercised early, say at time 𝜏𝜏 ∈ [t, 𝑇𝑇).
This means that portfolio F is worth 𝐾𝐾 at time 𝜏𝜏. However, even if the call
option is worthless, portfolio E would be worth 𝐾𝐾𝑒𝑒 𝑟𝑟(𝜏𝜏−𝑡𝑡) at time 𝜏𝜏.
It follows that portfolio E is worth more than portfolio F in all
circumstances.
 Hence, 𝑐𝑐𝑡𝑡 (𝐾𝐾) + 𝐾𝐾 ≥ 𝑃𝑃𝑡𝑡 (𝐾𝐾) + 𝑆𝑆𝑡𝑡 . Since 𝐶𝐶𝑡𝑡 (𝐾𝐾) = 𝑐𝑐𝑡𝑡 (𝐾𝐾), we have
𝐶𝐶𝑡𝑡 (𝐾𝐾) − 𝑃𝑃𝑡𝑡 (𝐾𝐾) ≥ 𝑆𝑆𝑡𝑡 − 𝐾𝐾.
(e) Since 𝑆𝑆0 − 𝐾𝐾 ≤ 𝐶𝐶 − 𝑃𝑃 ≤ 𝑆𝑆0 − 𝐾𝐾𝑒𝑒 −𝑟𝑟𝑟𝑟 , we have
31 − 30 ≤ 4 − 𝑃𝑃 ≤ 31 − 30𝑒𝑒 −0.08×0.25
or 2.41 < 𝑃𝑃 < 3.00.
Question 5.
A stock price is currently $100. Over each of the next two six-month periods it is
expected to go up by 10% or down by 10%. The risk-free interest rate is 8% per
annum with continuous compounding. What is the value of a one-year European
call option with a strike price of $100?
Answer.
$121
$21
$110

𝑓𝑓𝑢𝑢

$100
𝑓𝑓 $99
$0
$90

𝑓𝑓𝑑𝑑

$81
$0

We solve (𝑋𝑋, 𝑌𝑌) such that

121𝑋𝑋 + 1.04𝑌𝑌 = 21
99𝑋𝑋 + 1.04𝑌𝑌 = 0
It gives 𝑋𝑋 = 0.95455 and 𝑌𝑌 = −90.8658. Hence 𝑓𝑓𝑢𝑢 = 14.1347 and 𝑓𝑓𝑑𝑑 = 0.
We solve (𝑋𝑋, 𝑌𝑌) such that
110𝑋𝑋 + 1.04𝑌𝑌 = 14.1347
90𝑋𝑋 + 1.04𝑌𝑌 = 0
It gives 𝑋𝑋 = 0.7067 and 𝑌𝑌 = −61.1567. Hence 𝑓𝑓 = 9.5133.