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Solutions to Assignment 5

Chapter 16
2.

Only statement C is correct

4.

Call option with X=75


cost = 8 1/8 ; payoff = 5; profit = -3 3/8
Put option with X=75
Cost = 3;
payoff = 0;
profit = -3

5.

Walmart stock price = 100


Call option with X=100; six months till maturity; call premium (C) = $10
$10,000 available for investment
Value of investment at different stock prices:
Alt A: Buy 100 shares of W
Alt B: Buy 100 C
Alt C: Bills + Options
($9000 invested at 4%;
+ 100 calls)

80
$8000
0

100
$10000
0

110
$11000
$10,000

120
$12000
$20000

$9,360

$9,360

$10,360

$10,360

Rates of returns for the different strategies at different stock prices


Alt A: Buy 100 shares of W
Alt B: Buy 100 C
Alt C: Bills + Options
($9000 invested at 4%;
+ 100 calls)

80
-20%
-100%
-6.4%

100
0%
-100%

110
10%
0%

-6.4%

+3.6%

For questions 9, 10, and 13, please see me if you have any problems.

120
20%
100%
+13.6%

Chapter 17:
4.

Call option with the following characteristics:


X = 50;
T=1 year;
standard deviation = 20%; T-bill rate = 8%
What happens to the hedge ratio as stock price increases? Try three different stock
prices: $45, $50, and $55.
Hedge ratio = N(d1) from the Black-Scholes equation (refer to book or notes)
If S=45, d1 = -0.0268 and N(d1) = 0.489309
If S = 50, d1 = 0.5 and N(d1) = 0.6915
If S = 55, d1 = 0.97655 and N(d1) = 0.8356
This means the price of the call becomes more sensitive to changes in the price of
the underlying stock at higher stock prices.

5.

Two-state put option


S = 100; X=110; 1+r = 1.1
The stock price today is $100, At the end of the year, stock price will be either
$130 or $80
If the stock price increase to $130, put option will not be exercised so payoff =0
If the stock price decreases to $80, put option will pay $30 (i.e. buy the stock in
the open market for $80 and exercise the put option to sell the stock for X=110)
The hedge ratio (ratio of put option payoffs to stock payoffs)
= (0-30)/(130-80) = -30/50 = -3/5
So I will create the following portfolio

Buy 3 Shares
Buy 5 puts
TOTAL

CF today

CF one year from today


If S=130
If S=80

-300
-5P

3*130 = $390
0

3*80 = $240
5*30 = $150

-(300+5P)

$390

$390

Since the payoff is the same in either outcome, this is a riskless portfolio which
should earn 10% rate of return. So the most I would be willing to pay for it today
is the present value of $390 discounted at 10%
= 390/(1.1) = $354.54
In equilibrium,

300+5P = 354.54

So

P = $10.91

7.

T=0.5 years; X=50; S=50; r=10%;

std dev = 0.5

Use the Black-Scholes equation for call premium (refer to book or notes).
The call premium = $ 8.13
[Steps involved are
1.
calculate d1 (=0.3181) and N(d1) (=0.6248)
2.
calculate d2 (=-0.03536) and N(d2) (=0.4859)
3.
calculate C which turns out to be $8.13
14.

Call option with a high exercise price will have a lower hedge ratio.

20.

Hedge ratio of at-the-money call on IBM = 0.4


Hedge ratio of at-the-money put on IBM = -0.6
At-the-money straddle is formed by buying 1 call and 1 put. The sum of the two
individual hedge ratios gives the hedge ratio of the straddle
0.4 + (-0.6) = -0.2

23.

A collar is formed by buying 1 shares at S=50; buying one put with the exercise
price of $45; and shorting 1 call with the exercise price of $55.
In addition, we are told that for X=45, the N(d1) = 0.6
And for X=55, the N(d1) = 0.35
What happens to the value of the collar if there is a small rise in the stock price?
We need to calculate the sum of the individual deltas to determine the
delta of the portfolio.
Component of collar
Stock
Long P (x=45)
Short C (x=55)

Individual delta
1
N(d1)-1 = 0.6-1 = -0.4
-N(d1) = -0.35

The delta of the share is 1 since this asset will increase in value by $1 for
every $1 increase in the stock price
The delta of a put is given by N(d1) 1. The exercise price of the put is
$45 so the relevant N(d1) =0.6 and the delta of the put then is 0.4
The delta of a call is given by N(d1). The exercise price of the call is $55
so the relevant N(d1) = 0.35. However, we are shorting the call, so the
delta is 0.35
Adding the three individual delta yields 0.25. So, if the stock price
increases by $1, the value of the collar will increase by $0.25.

What happens to the delta of the collar if S becomes very large?


Delta of the collar approaches zero. Delta of the stock remains 1.
However, at high stock prices, the put is unlikely to be exercised (so its
delta will approach 0) while the call is very likely to be exercised (so its
delta will approach 1).
What happens to the delta of the collar if S becomes very small?
Delta of the collar will be zero. Again the delta of the stock remains 1. At
low prices, the put is very likely to be exercised (so its delta will approach
1) while the call is very unlikely to be exercised (so its delta will approach
0)

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