MGMT149 HW1

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Problem Set 1
Mgmt 149 Derivatives

Problem 1.24 Trader A enters into a forward contract to buy gold for $1000 an ounce in one year. Trader B buys a call option to buy gold for $1000 an ounce in one year. The cost of the option is $100 an ounce. What is the difference between the positions of the traders? Show the profit per ounce as a function of the price of gold in one year for the two traders. A will have the obligation to buy the gold at $1,000 per once regardless of the price which can lead to higher loss if the price decline. On the other hand, B can choose not to exercise the option right if the price is lower than $1,000 but B have to pay the premium for $100 per ounce which will lower the profit if the price goes up. Since B needs to pay the premium, the breakeven point of P for B is $1,100 while A s is only $1,000. Given the price of gold one year from now is P dollars per ounce. A profit (per ounce) = P 1,000 B profit (per ounce) = P 1,000 100 = P 1,100 if P > 1,000 B loss(per ounce) = $100 if P <= 1,000 For example, if P = 800, A will face $200 loss per ounce, while B will choose not to exercise the right and loss only the option premium of $100. The chart below show A s and B s profit in different prices per ounce one year from now.
1000 800 600 400 200 A's profit 0 -200 -400 -600 -800 -1000 B's Profit

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Problem 1.26 A US company knows it will have to pay 3 million euros in three months. The current exchange rate is 1.4500 dollars per euro. Discuss how forward and options contracts can be used by the company to hedge its exposure. Using the current exchange rate, the company would have to pay 1.45 x 3 = 4.35 million dollars in 3 months. If dollar appreciated, the rate will be lower and the company would have to pay less. However, if dollar depreciated, the rate will be higher and the company would have to pay more. To reduce the risk exposure with exchange rate, the company can use forward contract to fix the exchange rate which will fix the amount they have to pay at $4,350,000 regardless of the exchange rate. The company will enter the contract in the long position. On the other hand, the company could use the call option to reduce the risk as well and it will cost little compared to the loss by exchange rate. Let s assume the premium is $435,000 for the total and this option will allow the company to choose to buy the euro at $1.45 per euro. The chart below show how much the company has to pay after all.
6000000 5500000 5000000 4500000 4000000 3500000 3000000 1.10 1.15 1.20 1.25 1.30 1.35 1.40 1.45 1.50 1.55 1.60 1.65 1.70 1.75 1.80

Do Nothing Long Forward Call Option (Including the premium)

The call option seems to be the best in reducing the risk because it allows company to get lower rate if the exchange rate goes down and allows the company to pay the fixed rate if the rate goes up with the premium amount paid.

23995531 Problem 1.27 A stock price is $29. An investor buys one call option contract on the stock with a strike price of $30 and sells a call option contract on the stock with a strike price of $32.50. The market prices of the options are $2.75 and $1.50, respectively. The options have the same maturity date. Describe the investor's position. The following chart demonstrates the profit this investor will get at different stock price level.
5 4 3 2 1 0 -1 -2 -3 -4 25.50 26.00 26.50 27.00 27.50 28.00 28.50 29.00 29.50 30.00 30.50 31.00 31.50 32.00 32.50 33.00 33.50 34.00 34.50 35.00 35.50 36.00 36.50 Buy Call Option Sell Call Option Total Profit

By combining buying and selling the same stock s call option with same maturity date but different price, the investor can reduce the risk from both options by buying and selling at the same time. Doing this, he would get lower profit but will face lower loss if the price goes up (for selling call) or goes down (for buying call).

Problem 1.28 The price of gold is currently $600 per ounce. Forward contracts are available to buy or sell gold at $800 for delivery in one year. An arbitrageur can borrow money at 10% per annum. What should the arbitrageur do? Assume that the cost of storing gold is zero and that gold provides no income. The arbitrageur should borrow money at 10% per annum to buy the gold today and enter the forward contract to sell the gold at $800 in one year. He would borrow $600 per ounce today. One year from now, he would sell them in the forward contract at $800 per ounce. However, he will have to pay back the interest which is .10 x 600 = $60. So, his total gain will be $800 - $600 - $60 = $140 per ounce and he can get this gain without any risk.

23995531 Problem 1.30 The current price of a stock is $94, and three-month call options with a strike price of $95 currently sell for $4.70. An investor who feels that the price of the stock will increase is trying to decide between buying 100 shares and buying 2,000 call options (20 contracts). Both strategies involve an investment of $9,400. What advice would you give? How high does the stock price have to rise for the option strategy to be more profitable? It depends on the risk tolerance level of the investor. If he can take higher risk, option investment would be better and give higher profit. If his risk tolerance level is lower, stock would be a better investment. The graph below shows the return from both investments.
15600

10600

5600 Stock Option 600 92 -4400 93 94 95 96 97 98 99 100 101 102 103 104 105 106

-9400

The break-even point for the option is at $100 stock price when the option strategy will start to be more profitable and it will yield higher return as the stock price goes up.

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Problem 1.32 A trader buys a European call option and sells a European put option. The options have the same underlying asset, strike price and maturity. Describe the trader s position. Under what circumstances does the price of the call equal the price of the put? This is called Put-Call Parity which assumes that the European call option and the European put option have same underlying asset, strike price and maturity. Theoretically, the premium for put option and call option under this assumption should be the same. To illustrate this, we will further assume that there are two portfolios. Portfolio A consists of a call option for Stock S and the cash equal to the amount of strike price at maturity date (discounted to initial date). Portfolio B consists of a put option and 100 shares of Stock S (valued at the initial date).
160 140 120 100 80 60 40 20 0 160 140 120 100 80 60 40 20 0

60 70 80 90 100 110 120 130 140 150


Cash Call Option Portfolio A

60 70 80 90 100 110 120 130 140 150


Stock Put Option Portfolio B

Suppose the strike price is $1 and the option price is $30 (per 100 shares), there is no interest rate, and the initial price of the stock is $100. Investing in either portfolio A or portfolio B would yield the same result. Since the return would be the same, the cost of both portfolios should be the same. We can also write it in term of equation.

Pc + C / (1 + r)n = Pp + S0
Pc = Price of call option C = Cash equal to r = Interest rate (per period) n = Number of periods Pp = Price of put option S0 = Initial price of underlying

The reason why this is applied to European option is that it can be exercised only at the specified time, so we can calculate the value of the option. This put-call parity theory where the price of the same underlying asset, strike price and maturity put and call option prices will be the same is when there is no arbitrage opportunity and it s the European option.

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