2023 Tutorial 6 Questions Options – FTX3045S

Question 1

During a game of croquet, two investors, Tweedledee and Tweedledum, discuss their neutral to bearish

outlook about Gryphon stocks (GRN). Tweedledee would like to invest in GRN stocks, however, is unwilling

to bear losses beyond some given level. Tweedledum on the hand decides that he would like to write a call

on GRN stock but is concerned about the consequences of naked option writing.

a. Which option strategies would you recommend for each investor? Your answer should include a brief

description of each strategy recommended

(4 marks).

b. You are provided with the following information table:

Gryphon (GRN) Underlying stock price:

R120

Expiration X Co Po

September 21, 2023 R105 ? R2,10

September 21, 2023 R135 R1,80 R6,50

i. Comment on whether Co for X = 105, would be higher or lower than the Co for X = 135? Provide

a brief motivation for your answer.

(2 marks)

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ii. Suppose that the strategies you recommended above in (a) were based on exercise prices equal

to R135 and with expiration dates of 21 September 2023. Suppose further that the underlying

stock price of GRN at expiration is trading at R115, calculate the profit (or loss) for each of the

two investors based on your recommended strategies. Show all your workings.

(6 marks)

c. Hatter has Tweedledee and Tweedledum over for tea and they brag about the option strategies you

recommended to them. Hatter wonders if such an option strategy exists that would combine both

the option strategy you recommended to Tweedledee and the option strategy you recommended to

Tweedledum. Suggest such an option strategy for Hatter and provide a brief description.

(2 marks)

d. Alice also attends Hatter’s tea party and overhears all the conversations around option strategies.

Alice however is a very risk-averse investor and is distrusting of options. She would prefer to invest

in GRN stocks directly.

i. List and briefly explain two features that investing in GRN options would offer Alice that direct

stock investments would not.

(2 marks).

ii. Assume that the current underlying stock price of GRN is still R120. And assume that the

option prices listed in table (b) based on X = R135 and expiration date 21 September 2023 for

GRN are still valid. If Alice has R10 000 to invest, how many shares of GRN stock can she invest

in today through direct stock purchases? And how many option contracts on GRN stock can

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 she hold instead, using the same R10 000 investment? Round your answers off to the nearest

whole number.

(2 marks)

e. Cheshire is strongly bearish about GRN stocks and decides to hold a bearish spread position using the

information provided in table (b).

i. Calculate the costs of establishing this bearish spread position?

(3 marks)

iii. If the price of GRN stock at expiration is trading at R130, what would Cheshire’s total payoff

be?

(3 marks)

f. Dormouse, a speculative trader, is anxiously awaiting news of a merger between GRN and Knave of

Hearts Ltd (KNH). He speculates that there will be a massive jump in the price of GRN’s stock price

but is uncertain about the direction of the move. What option strategy would you recommend he

take out? Provide a brief description of this strategy.

(2 marks)

g. White Rabbit however believes that everyone is expecting the merger mentioned in (f) above, and

therefore believes that any news or announcement concerning this would not affect GRN stock prices

drastically. White Rabbit therefore has a market-neutral outlook on GRN and would like to use his

outlook of low-price volatility to make a conservative profit while still limiting his risk.

i. What spread strategy would you recommend White Rabbit take out? (1 mark)

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 ii. Explain in detail how White Rabbit should go about creating this strategy using the

information table below: (3 marks)

X Co

R90 R16

R110 R13

R130 R11

iii. Calculate the cost of establishing this strategy

(3 marks)

iv. If GRN stock is trading at R109 when this strategy expires, calculate the total payoff

that White Rabbit could expect to receive?

(3 marks)

Question 2

Assume that the current stock price of Caterpillar Ltd is R130 and that the stock does not pay a dividend.

Further assume that the risk-free interest rate is 7% per annum compounded annually. In addition, assume

that a 3-month European put option on Caterpillar Ltd’s stock is currently selling for R15. Assume also that

the exercise price is R140. Further assume that a 3-month European call option on the same underlying stock

with the same maturity and strike price is currently selling at R20.

Given the information above, assess if Put-Call Parity has been violated and if an arbitrage opportunity

exists? If yes, show how you would take advantage of this mispricing. Also, calculate the arbitrage profit that

you can expect to earn.

(10 marks)