Practice Problems

Set Number 2

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 Practice Problem - Set Number 2
Put Call Parity
The Put Call parity relationship is an important building block. For European options the following
holds:
Protective Put = Fiduciary Call
Po + So = PV(X) + Co where X = Option strike price
From that we derive that a stock can be replicated from options and a Zero Coupon Bond: So =
PV(X) + Co - Po, or a Zero Coupon Bond can be replicated from equity instruments: PV(X) = Po
+ S o - Co

The above relationships assumes there are no dividends. However, the adjustment for dividends is
simple: Po + So – PV(Dividends) = PV(X) + Co
The intuitive is that when dividends are paid the value of a stock theoretically drops. Think in
terms of the dividend discount model. A share of Stock is the value of a stream of dividends and
as they are received the stock value adjusts/drops.

For individual stocks, dividends are paid at discrete intervals, usually quarterly. However if we are
dealing with an Index, for instance the S&P 500, a reasonable but simplifying assumption is to
work with the dividend yield and adjust the put call parity relationship as follows:
Po + Soe-T = X e-rT+ Co

All options described in the following problems are European. Assume continuous compounding.

Q1) AIG’s stock sells for $100. A 6 month call option sells for $10.50. A dividend of $1.00 is paid
quarterly with the next one due in 3 months. The risk free is 10%. The strike rate is $100. Compute
the implied value of a 6 month put?

Q2) If a 6 month put option on AIG stock in Q1) above is being offered in the market at $9.00, is
there an arbitrage opportunity? Show how you would take advantage of it.

Q3) Assume you execute the arbitrage trade recommended in Q2). Show all of your initial cash
flows and all of those that would materialize in 6 months if the stock dropped 50%, stayed the
same or increased 50% from current levels. Assume that all dividends received will be reinvested
at the risk free rate. Have you captured the arbitrage profit?

Q4) The S&P Index is currently 2,000. A 1 year call option sells for $212.45 and a 1 year put for
$104.95. The dividend yield on the index is 2% and the risk free rate is 5%. The strike rate is 1,950.
Is the call fairly priced?

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Q5) How would you take advantage of the arbitrage opportunity in Q4)? Show all cash flows if
the Index is at 0 at the end of year or hits 6,000?

Q6) Assume the same set of assumptions as in Q4) but assume that both options are fairly priced.
On that basis what does the dividend yield need to be to eliminate arbitrage?

Q7) Assume you own the broad market Index which is currently trading at 1,900. The risk free
rate is 10% and the dividend yield is 0%. Options actively trade on the Index but the financial
regulator has banned outright selling or shorting the stock. You don’t want to have to invest any
more in your position but want to eliminate the downside risk over the next year? What option
strategy would your pursue to achieve both objectives?

Q8) Recommend a futures strategy that would also give you the same result as in Q7).

Q9) Show that across index level of 500 and 5,000 both the options strategy in Q7) and the futures
strategy in Q8) give the same results. What is the return on your stock investment with the various
“hedges”?

Q10) If you are long both a Put Option and a Call Option on the Index at the same Strike Rate
what is the breakeven price or prices for your “bet on volatility” if you paid Po for the put and Co
for the call.

Forward and Futures Pricing

For purposes of these examples we assume that the techniques for pricing forward and futures are
the same. In the following examples use continuous compounding.

Q11) JPM’s stock currently sells for 100.00 and pays no dividend. The risk free rate is 6% and
the 1 year Futures on the stock is being offered in the market at 110. Is there a market mispricing?
If so, show the details of the trade to capture the arbitrage opportunity. Show the payoffs in year 1
if the stock is up 50% or down 50%.

Q12) Using the same details in Q11) above. Assume you were not provided with the risk free rate
but instead were told that a Futures price of 110 is the theoretically fair price. Therefore, what’s
the implied risk free rate?

Q13) GE’s stock currently sells for 100.00 and pays no dividends. The risk free rate is 3.5% for
the next year and the 1 year forward risk free rate in year 2 is 7%. A 2 year Futures on the stock is
being offered in the market at 108. Is there a mispricing? Show the details of any arbitrage trade
you would recommend. Show the payoffs at the end of year 2 if the stock is up 50% or down 50%.

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Q14) Assume a share of Google trades at 400.00. The risk free rate is 3% and Google will pay a
dividend of 4.50 in one year. If a 1 year futures contract on Google trades at 405.00 is there an
arbitrage opportunity? Show the payoffs at the end of year 1 if the stock is up 50% or down 50%.

The following two questions deal with arbitrage opportunities when the stock has a bid-ask spread.
The Bid level is the price a broker will buy a security from an investor while the Ask level is the
price they will sell to the investor.

Q15) Assume the S&P Index has a bid level of 1,200 and an ask level of 1,220. The borrowing
rate is 6% and the lending rate is 3%. A 12.00 dividend is expected at the end of the year. Is there
an arbitrage opportunity if the price of a 1 year futures is 1,210? Show the payoffs at the end of
year 1 if the index is up 50% or down 50%.

Q16) Assuming the same details as in Q15), however the 1 year futures is 1,290. Is there an
arbitrage opportunity? Show the payoffs at the end of year 1 if the stock is up 50% or down 50%.

Q17) A 6 month forward contract on the Index is 1,850. The index is currently at 1,800 has a
dividend yield of 4% and the risk free rate is 10%. Is there an arbitrage opportunity? Show all cash
flows after 6 months if the index is up 50% or down 50%.

Q18) Assume that the current exchange rate (the FX rate) for US$/UK£ = 2.00. Therefore 1 UK
pound is worth 2 US Dollars. 1 year risk free rates are 5% in the US and also 5% in the UK. If the
1 year forward for US$/UK£ is 3.00, is there an arbitrage opportunity? Show your results at the
end of year 1.

Q19) Assume that the current exchange rate (the FX rate) for US$/UK£ = 2.00. 1 year risk free
rates in the US are 10% and 1 year rates in the UK are 5%. If the 1 year forward US$/UK£ is 1.60,
is there an arbitrage opportunity? Show your results at the end of 1 year.

Q20) A share of BofA is currently 60.00. The risk free rate is 6%. The quarterly dividend is 0.50
and the next dividend is paid 3 months from now. If a 1 year forward is offered at 61.00, is there
an arbitrage opportunity? Show all cash flows at the end of year 1 if the index is up 50% or down
50%.

Q21) In Q20) if instead of having quarterly discrete dividends, solve for the continuous dividend
yield that would derive the same futures price you already computed?

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 Solutions to Problem Set 2
A1) Based on parity Po = -[So – PV(Dividends)] + PV(X) + Co
Where PV(Dividends) = 1.00 e-0.10×0.25 + 1.00 e-0.10×0.50 = 1.9265
PV(X) = 100 e-0.10×0.50 = 95.1229
Po = -[100 – 1.9265)] + 95.1229 + 10.50 = 7.5494

A2) The arbitrage opportunity is Market – Implied Value = 9.00 – 7.5494 or 1.4506.
The basic principals in executing an arbitrage opportunity are:
• sell/short the security if it is overvalued in the market or buy if undervalued
• hedge your exposure to the market risk in the transaction so you capture just the mispricing
• borrow or lend any net proceeds so you have none of your own capital at risk
In this case the Put is overvalued. So you will sell a Put option for 9.00.

To hedge that transaction we know that a Put can be replicated by a combination of other securities
as follows: Po = -[So – PV(Dividends)] + PV(X) + Co

A portfolio of + Po + [So – PV(Dividends)] - PV(X) - Co should theoretically have a value of zero

and have no market risk. In our case we will sell the P so in reversing the signs in the relationship
above we have - Po - [So – PV(Dividends)] + PV(X) + C.

To execute the arbitrage, at time 0:

Cash Flow Time 0
Sell the Put +9.00
Short the Stock +100.00
Buy a Call -10.50
Lend Net PV(X) & PV(DIVs) -97.05
Net Cash Flow/Arb Profits +1.45

The net proceeds is the Net of: PV(Dividends) + PV(X) = +1.9265 + 95.1229 = 97.05

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A3) The payoffs if the stock finishes at 50, 100 or 150, with a strike rate of 100 is:

Cash Flows at Various Stock Prices

Cash Flow Time 0 50 100 150
Sell the Put +9.00 -50 0 0
Short the Stock +100.00 -50 -100 -150
Pay Dividends1 -2.025 -2.025 -2.025
Buy a Call -10.50 0 0 50
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Lend Net PV(X) & PV(DIVs) -97.05 102.025 102.025 102.025
Net Cash Flow/Arb Profits +1.45 0.00 0.00 0.00

1 Future Value of Dividends = 1.9265e+0.10×0.50 = 2.025. Dividends will be paid to the counterparty
from whom you borrowed/shorted the stock. As the put and hedge mature you will pay the stock
proceeds to the counterparty including the dividends. Technically the dividends would be paid
along the way but the handling above with assumed cost of funds is the same as paying as you go
and incurring financing charges.
2 Lending will grow to = 97.05 e+0.10×0.50 = 102.025

So you have capture the mispricing by selling the put and through your hedge have eliminated
exposure to market moves when the put expires.

A4) Based on parity Co = Po +[So – PV(Dividends)] - PV(X)

Where [So – PV(Dividends)] = 2000 e-0.02×1.00 = 1,960.397
PV(X) = 1,950 e-0.05×1.00 = 1,854.8974
Co = 104.95 + 1,960.3973- 1,854.8974 = 210.45
Call is overpriced by 212.45 – 210.45 = 2.00. So there is an arbitrage opportunity.

A5) To capture the trade we would sell the overpriced security, in this case the call, and hedge the
outcome. Since Co = Po +[So – PV(Dividends)] - PV(X) selling a call will result in the following
hedge: - Co + Po +[So – PV(Dividends)] - PV(X)

The cash flow at time zero and at ending Index levels at a Strike of 1,950 are:
Cash Flows at Various Index Level
Cash Flow Time 0 0 6,000
Sell Call +212.45 0 -4,050
But Put -104.95 +1,950 0
Buy Index -2,000.00 0 6,000
Receive Dividends 1 41.63 41.63
Borrow PV(X) & PV(DIVs) +1,894.50 -1,991.63 -1,991.63
Net Cash Flow/Arb Profits +2.00 0.00 0.00

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1Since [So – PV(Dividends)] = 2000 e-0.02×1.00 = 1,960.397 implies PV (Dividends) = 39.60
Therefore PV(X) + PV (Dividends) = 1,854.8974 + 39.60 = 1,894.50.
The future value of the Dividends is 39.60 e0.05×1.00 = 41.63

A6) We know that Co = Po +[So – PV(Dividends)] - PV(X) or

PV(Dividends) = Po + So - PV(X) - Co = 104.95 + 2,000 - 1,854.8974 – 212.45 = 37.6026 or
$2 less.

Therefore PV(Dividends) = So - Soe-T = 2,000 – 2,000e-×1.00

37.6026 = 2,000 – 2,000e-×1.00
-(37.6026- 2000) / 2000 = e-×1.00
Ln[-(37.6026 - 2000) / 2000] = -×1.00
-0.01898 = -
Dividend Yield = 1.898%
A7) The two constraint are, you want to eliminate downside volatility and you want to do it with
zero cost. On that basis the way to achieve this using options is to enter into a strategy where you
buy a put option to eliminate the downside but sell a call option to finance it. However in doing
that you also give away the upside. To achieve that at a zero cost we know that the cost of a put
and a call are equal when the strike rate for a zero dividend asset is: X = So erT = 1,900 e0.10×1.00 =
2,099.8247. Buying a put and selling a call at this level will create a known payoff at the end of
year 1 of 2,099.8247.

A8) To enter into a zero cost Futures contract and create a hedge, we would Sell a Futures Contract
at a price of F0,T = So erT or 1,900 e0.10×1.00 = 2,099.8247
A9) The following table captures the results for the various hedges.
Cash Flows at Various Index Level
Cash Flow Time 0 500 5,000
Options Strategy
Already owned Stock 500 5,000
Sell Call +Same Price as Put 0 2,099.8247 – 5,000
Buy Put - Same Price as Call +2,099.8247 – 500 0
Total +2,099.8247 +2,099.8247
Futures Strategy
Already owned Stock 500 5,000
Short Futures -(500-2099.8247) -(5,000-2099.8247)
Total +2,099.8247 +2,099.8247
The outcome is the same in all scenario and generated the risk free rate of 10%.

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A10) The cost of entering into the strategy is the combined premium on both options -(Po+Co).
Therefore if the stock price drops to [Strike Rate - (Po+Co)], then the put option will provide a pay-
off that covers the initial cost. Similarly if stock price increases to [Strike Rate + (Po+Co)], the call
option will provide a pay-off that covers the initial cost.

A11) The fair value of the futures contract is F* = S0erT at time T assuming no dividends. Given
a risk free rate of 6% and 1 year to maturity F* = S0erT = 100e0.06×1 = 106.1837. If the market is
pricing this contact at 110.00 then there is an arbitrage opportunity to sell the overpriced security
(in this case the futures contact) and hedge it. Using none of your own capital you can capture the
mispricing as follows:
Cash Flows at Various Stock Levels
Cash Flow Time 0 50 150
Sell Futures Contract 0 110.00 - 50 110.00 - 150

Buy Stock -100 50 150

Borrow Proceeds @ e0.06×1 +100 -106.1837 -106.1837
Total 0 +3.8163 +3.8163

This demonstrates that you captured the mispricing regardless of stock volatility.

A12) Assume that the fair value of F* = S0erT = 110.00. Therefore solve for r as follows:
100er×1 = 110.00
er×1 = 110.00 / 100.00 = 1.10

To solve for the exponent of r we need to take the natural log of each side:
r×1× ln e= ln(1.10)
Since the ln e = 1, we arrive at r = Ln(1.1) / 1 = 9.531%
You can confirm your results since 100e0.09531×1 = 110.00.

A13) To price a 2 year futures using continuous compounding:

F* = S0 e0.035×1 × e0.07×1
= 100 e0.035×1 × e0.07×1
= 100 × 1.03562 × 1.072508 = 111.0711

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Futures market price is 108, therefore it’s underpriced. To take advantage of the arbitrage
opportunity, buy the Futures contract and hedge and finance as follows:

Cash Flows at Various Stock

Cash Flow Time 0 50 150
Buy Futures Contract 0 50 - 108.00 150 -108.00

Short Stock +100 -50 -150

0.035×1 0.07×1
Lend Proceeds @ e ×e -100 +111.0711 +111.0711
Total 0 +3.0711 +3.0711

A14) With discrete dividends (that is expressed in dollars and not yield) the fair price of the futures
is: F* = S0erT - FV(Dividends).
The future value of the dividends is this case are simply 4.50 and are received at the end of the
year. Therefore F* = 400 e0.03×1 – 4.50 = 407.6818. The futures contract on offer has a price of 405.
Therefore there is an arbitrage opportunity of 407.6818 – 405 or 2.6818. This can be captured as
follows by buying the underpriced futures contract:
Cash Flows at Various Stock
Cash Flow Time 0 200 600
Buy Futures Contract 0 200- 405.00 600 -405.00

Short Stock +400 -200 -600

Pay Back Dividends to short stock counterparty -4.50 -4.50
Lend Proceeds @ e0.03 -400 +412.1818 +412.1818
Total 0 +2.6818 +2.6818

A15) Where there is a difference in the Bid-Ask price and a difference in the borrowing (B) and
lending rates (L) the fair value of a futures contract is not a single value but falls within the
following range:
S0 BideL×T - FV(Dividends) < F* < S0 AskeB×T - FV(Dividends)
Typically the Ask Price > Bid Price and the Borrowing Rate > Lending Rate, which make both
favorable to the dealer / broker in the transaction.

Using our values: 1,200e0.03×1 - 12 < F* < 1,220e0.06×1 – 12. Therefore the band within which the
Fair futures value can fall is 1,224.5454 to 1,283.4406.

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If a futures contact in the market is priced at 1,210 then it’s undervalued. Therefore buy the futures
contract and capture the arbitrage opportunity as follows:
Cash Flows at Various Stock
Cash Flow Time 0 600 1,800
Buy Futures Contract 0 600- 1,210 1,800 -1,210

Short Index +1,200 -600 -1,800

Pay Back Dividends -12.00 -12.00
Lend Proceeds @ e0.03 -1,200 +1,236.5454 +1,236.5454
Total 0 +14.5454 +14.5454

You have captured the mispricing of 1,224.5454 – 1,210.00 or 14.5454.

A16) If the market is priced at 1,290, there is an arbitrage opportunity from selling the futures as
follows:
Cash Flows at Various Stock
Cash Flow Time 0 600 1,800
Sell Futures Contract 0 1,290- 600 1,290 -1,800

Buy Index -1,220 +600 +1,800

Receive Dividends +12.00 +12.00
Borrow Proceeds @ e0.06 +1,220 -1,295.4406 -1,295.4406
Total 0 +6.5594 +6.5594

Have captured mispricing of 1,290.00 – 1,283.4406 or 6.5594.

A17) The forward price given a dividend yield (δ) is F* = S0 e(r −δ)×T
or 1,800 e(0.10 −0.04)×0.50 = 1,854.8182
The futures contract is offered in the market at 1,850 so there is an arbitrage opportunity from
buying a futures contract of 4.8182 that can be captured as follows:
Cash Flows at Various Stock
Cash Flow Time 0 900 2,700
Buy Futures Contract 0 900- 1,850.00 2,700 -1,850.00
Short Index +1,800 -900 -2,700
Pay Back Dividends1 -37.4697 -37.4697
Lend Proceeds @ e0.10×0.5 -1,800 +1,892.2879 +1,892.2879
Total 0 +4.8182 +4.8182
1 FV(Dividends) = SoerT - Soe(r-)T = 1,800 e0.10×0.50 - 1,800 e(0.10-0.04)×0.50 = 37.4697

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A18) The fair price for a 1 year forward FX is US/GP x e(r$%−r£%) ×1.0 = 2.00 e(0.05−0.05) ×1.0 = 2.00.
If a 1 year forward FX is being offered in the market at 3.00 then UK £’s are overvalued. The fair
value of a £ should be $2 but the forward market is pricing each £ to be worth $3 in a year.
To take advantage of this opportunity you want to own a FX forward to sell £’s in a year and
purchase $’s.

The transaction is to enter into a forward to sell £’s in a year and convert to $’s.

Hedge the transaction as follows:

• borrow right now in US dollars
• convert that to £’s and lend those proceeds in the UK
• at the forward maturity, convert £’s back to $’s and pay off loan and keep difference

To demonstrate the transaction and hedge assume you borrow $2 in the US to lend in the UK.

Cash Flow Time 0 Cash Flows at Maturity

FX Forward to Sell £’s 0

Hedge
Borrow in US @ e0.05×1.0 +$2 -$2.1025
Convert to UK at $2/£1 at time 0
Lend in UK /£1 @ e0.05×1.0 -£1 +£1.0513

Final step - Execute the Forward and Pay off the US loan:
• Covert the +£1.0513 at the FX Forward rate of 3.00. Sell £1.0513 and receive $3.00 x
1.0513 = $3.1539
• Pay off the US loan and net $3.1539 -$2.1025 = $1.0514

This differential is basically the mispricing on the Forward times the UK borrowing rate.

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A19) The fair price for a 1 year forward FX is US$/UK£ x e(r$%−r£%) ×1.0 = 2.00 e(0.10−0.05) ×1.0 =
2.1025. The 1 year forward FX offered at 1.60 implies the $ is overvalued. UK investors should
be able to purchase $2.1025 for £1 but will only receive $1.60. To take advantage of this
opportunity investor wants to own an FX forward to sell the overvalued currency in a year.
Therefore own $’s in a year by borrowing in £’s today.

Cash Flow Time 0 Cash Flows at Maturity

FX Forward to Sell $’s 0

Hedge
Borrow in UK @ e0.05×1.0 +£1 -£1.05127
Convert to UK at $2/£1 at time 0
Lend in US / 2 @ e0.10×1.0 -$2 +$2.21034

Final step Execute the Forward and Pay off the US loan:
• Covert the +$2.21034 at the FX Forward rate of 1.60. Sell $2.21034 and receive 1/1.60
2.21034 = £1.381464.
• Pay off the UK loan and net £1.381464-£1.05127= £0.330194

If you were a US investor you would as a final step convert the £0.330194 to US dollar at the
prevailing spot rate. If it ended up being the forward fair value then it would be £0.330194 x 2.1025
= $0.694233.

A20) Since the dividends are discrete the following should be the fair price of the future:
F* = S0erT - FV(Dividends)

Assuming dividends are reinvested at the risk free rate the future value is:
0.50e0.06×0.75 + 0.50e0.06×0.50 + 0.50e0.06×0.25 + 0.50 = 2.0458
Therefore F* = 60e0.06×1 – 2.0458 = 61.6644. Give that the future is priced in the market at 61.00
there is an arbitrage opportunity to buying it and hedging.
Cash Flows at Various Prices
Cash Flow Time 0 30 90
Buy Futures Contract 0 30- 61 90- 61
Short Stock +60 -30 -90
Pay Back Dividends -2.0458 -2.0458
Lend Proceeds @ e0.06×1.0 -60 +63.7102 +63.7102
Total 0 +0.6644 +0.6644

This trading and hedging strategy captured the mispricing of 61.6644 -61 = 0.6644.

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A21) Solve for dividends yield as F* = S0 e(r −δ)×T = 60 e(0.06 –Div%)×1.0 = 61.6644
e(0.06 –Div%)×1.0 = 61.6644 / 60 = 1.027740
(0.06 –Div%)×1.0 = ln(1.027740) = 0.027362
Div% = 0.06 - 0.027362 = 0.032638 or 3.2638%

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