Question 1

Suppose an investor contacted a broker on Monday, January 8 and placed an order to take a short
position in 5 March on gold futures contracts. Further suppose that at the time the order was
executed, the March gold futures price was 650 dollars per troy ounce. The size of each contract
is 100 troy ounces.

The broker required the investor to post an initial margin of $2,500 per contract. The broker also
informed the investor that the maintenance margin was $1,000 per contract.

Answer the following questions.

A. Assuming the investor closes out the position at the settlement price on Friday, January 12,
fill out the following table.



Date
March Gold
Futures
Settlement
Prices

Mark-
to-
Market
Add/Withdraw
To/From
Margin
Account


End-of-Day
Balance
1/8 open 650 Nothing needs to
be entered here

Nothing needs to
be entered here
1/8 settle 645


1/9 settle 655
1/10 settle 660
1/11 settle 670
1/12 settle 615 0

B. Compute the gain/loss on the futures position. Ignore commission charges.













Solution:
A.



Date
March Gold
Futures
Settlement
Prices

Mark-
to-
Market
Add/Withdraw
To/From
Margin
Account


End-of-Day
Balance
1/8 open 650 Nothing needs to
be entered here
$12,500
Nothing needs to
be entered here
1/8 settle 645 $2,500

$15,000
1/9 settle 655
$5,000

$10,000
1/10 settle 660
$2,500

$7,500
1/11 settle 670
$5,000

$10,000

$12,500

1/12 settle 615 $27,500

$40,000
0

B.
40,000 12,500 10,000 = (5)(100)(650 615) = $17,500


Question 2

The price of gold is currently $500 per ounce. Forward contracts are available to buy or sell gold
at $700 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.

Solution:
The arbitrageur should borrow money to buy a certain number of ounces of gold today and short
forward contracts on the same number of ounces of gold for delivery in one year. This means
that gold is purchased for $500 per ounce and sold for $700 per ounce. As long as the cost of
borrowed funds is less than 40% per annum this generates a riskless profit.
700=500*(1+r) r = 40%









Question 3

Suppose the spot price of corn (a pure consumption commodity) is $4.75 per bushel. Storage
costs are $0.60 per bushel per year payable semiannually in advance, i.e., $0.30 now for the first
six months and $0.30 in six months for the next six months. The interest rate is 6 percent per
year with continuous compounding. Answer the following questions.

A. Suppose the actual quoted price for a six-month forward contract is $5.50 per bushel. Explain
whether or not there is an arbitrage opportunity. If one does exist, use an arbitrage table to
demonstrate how you can make a riskless arbitrage profit. Note that the arbitrage table should
have the following column titles: Transaction, Payoff (now), and Payoff (6 months).

B. Suppose the actual quoted price for a six-month forward contract is $5.05 per bushel. Explain
whether or not there is an arbitrage opportunity. If one does exist, use an arbitrage table to
demonstrate how you can make a riskless arbitrage profit. Note that the arbitrage table should
have the following column titles: Transaction, Payoff (now), and Payoff (6 months).

C. Using the actual quoted forward price of 5.05 per bushel in part B., compute the implied
convenience yield, y, of corn.

Solution:

A. For a consumption commodity:

20 . 5 e ) 30 . 0 75 . 4 ( e ) U S ( F
) 50 . 0 )( 06 . 0 ( rT
actual
= + = + s

Since the actual forward price is greater than 5.20, an arbitrage position is feasible. In this case,
short the forward contract and buy corn. See table below.



Transaction

Payoff (now)

Payoff (6 months)

Short Forward


Buy Spot


Borrow to Buy Spot


Pay Storage


Borrow 0.30 for 6
Months

0


4.75


+ 4.75


0.30


+ 0.30

5.50
T
S


+
T
S


) 50 . 0 )( 06 . 0 (
e 75 . 4




) 50 . 0 )( 06 . 0 (
e 30 . 0

Net


0

bushel per 30 . 0
e ) 30 . 0 75 . 4 ( 50 . 5
) 50 . 0 )( 06 . 0 (
=
+




B. Since the actual quoted forward price, 5.05, is less than 5.20, there is not an arbitrage
opportunity. For a pure consumption commodity, selling the commodity and taking a long
position in the forward contract is not feasible.

C. Using the actual quoted forward price of 5.05 per bushel in part B., compute the implied
convenience yield, y, of corn.

) 50 . 0 )( 06 . 0 ( ) 50 . 0 )( y (
e ) 30 . 0 75 . 4 ( e ) 05 . 5 ( + =


) 50 . 0 )( 06 . 0 ( ) 50 . 0 )( y (
e ) 05 . 5 ( e ) 05 . 5 ( =


) 50 . 0 )( 06 . 0 ( ) 50 . 0 )( y (
e e =

y = 0.06 or 6%






Question 4

The current spot price of silver is $12.50 per ounce, and the risk-free rate of interest is 5.13% per
year with annual compounding. The standard cost to store large quantities of silver in a secure
storage facility is $0.05 per ounce every four months payable in advance. Answer the following
questions.

A. Compute the delivery price for a 12-month forward contract taken out today (i.e., the forward
price that is consistent with a zero value for the forward contract).

B. Suppose the 12-month forward contract referred to in part A is to buy 100,000 ounces of
silver, and suppose that we are now 8 months into the life of the contract (i.e., the contract has a
remaining maturity of 4 months). Compute the market value of this previously-issued forward
contract assuming the spot price of silver in 8 months is $15.55 per ounce.

Solution:
A. 05 . 0 050027493 . 0 ) 0513 . 1 ln( r ~ = =

1475 . 0 e 05 . 0 e 05 . 0 05 . 0 U
) 12 / 8 )( 05 . 0 ( ) 12 / 4 )( 05 . 0 (
= + + =



30 . 13 e ) 6475 . 12 ( e ) 1475 . 0 50 . 12 ( e ) U S ( F K
) 1 )( 05 . 0 ( ) 1 )( 05 . 0 ( rT
= = + = + = =

B. 86 . 15 e ) 05 . 0 55 . 15 ( F
) 12 / 4 )( 05 . 0 (
= + =

69 . 768 , 251 $ e ) 30 . 13 86 . 15 )( 000 , 100 ( f
) 12 / 4 )( 05 . 0 (
= =



or

97 . 982 , 251 $ ) e 30 . 13 05 . 0 55 . 15 )( 000 , 100 ( f
) 12 / 4 )( 05 . 0 (
= + =

















Question 5

In the following situations, indicate whether a long or short position is appropriate and compute
the optimal number of contracts.

A. A jewelry manufacturer would like to hedge the purchase of 1,000 ounces of gold using gold
futures. One gold futures contract is for the delivery of 100 ounces of gold.

B. A wholesaler of pork bellies would like to hedge the sale of 280,000 pounds of pork bellies
using pork belly futures. One pork belly futures contract is for the delivery of 40,000
pounds.

C. An energy products distributor has a fixed-price contract to sell 36,000 barrels of oil at a
price of $28 per barrel in 3 months. One oil futures contract is for the delivery of 1,000
barrels of oil.

D. Statistical analysis indicates that the secondary-market price of Pokeman cards is inversely
correlated with the futures price of baseball cards. Indeed, a regression of the secondary-
market price of Pokeman cards on the futures price of baseball cards has a statistically
significant (slope) coefficient of 2.60 and an R
2
of 75%. A dealer in Pokeman cards would
like to use this information to hedge variation in the value of his inventory of 10,000
Pokeman cards. One baseball card futures contract is for the delivery of 500 baseball cards.

E. Platinum and gold prices tend to be highly correlated. However, platinum prices tend to be
less volatile than gold prices. A regression of the spot price of platinum on the futures price
of gold has a statistically significant (slope) coefficient of 0.65 and an R
2
of 89%. A Russian
platinum mine would like to use this information to hedge the sale of 1,200 ounces of
platinum. One gold futures contract is for the delivery of 100 ounces of gold.

F. Heritage Rare Coins (located in Dallas and the largest rare coin dealer in the world) has
agreed to sell its entire inventory of 2,000 $20 gold pieces (each minted in the 1900s and
each approximately one ounce of pure gold) for $1,750 per coin to another rare coin dealer in
June of this year. Heritage would like to hedge this transaction using gold futures. A
regression of $20 gold piece prices on the futures price of gold has a statistically significant
(slope) coefficient of 5.80 and an R
2
of 55%. One gold futures contract is for the delivery of
100 ounces of gold.

Solution:
A. LONG: (1,000)/(100) = 10 futures contracts
B. SHORT: (280,000)/(40,000) = 7 futures contracts
C. LONG: (36,000)/(1,000) = 36 futures contracts
D. LONG: (2.6)[(10,000)/(500)] = 52 futures contracts
E. SHORT: (0.65)[(1,200)/(100)] = 7.8 or 8 (rounded up) futures contracts
F. LONG: (5.80)[(2,000)/(100)] = 116 futures contracts


Question 6

A company would like to hedge the purchase of pink widgets (PW) with a long position in
futures contracts on magenta widgets (MW). A regression of the spot price of pink widgets (
PW
S ) on the futures price of magenta widgets (
MW
F ) resulted in the following equation:

86 . 0 R F 50 . 0 75 . 0 S
2
MW PW
= + =

The company plans to purchase 100,000 pink widgets in two months. The current spot price of
pink widgets is $7 per widget and the current futures price of magenta widgets for delivery in 3
months is $12.50 per widget. Each futures contract is for delivery of 10,000 magenta widgets.
Answer the following questions.

A. What is the minimum variance hedge ratio (
-
h ) and optimal number of futures contracts (
-
N )?

B. The company projects two extreme outcomes in two months: (1) 75 . 9 S
PW
= and 18 F
MW
=
and (2) 75 . 3 S
PW
= and 6 F
MW
= . Compute the net cost to the company under each
outcome in order to show that your
-
h in part A is the minimum variance hedge ratio.

Solution:

A. contracts 5
000 , 10
000 , 100
) 50 . 0 (
contract futures one Units
hedged Units
h N 50 . 0
dF
dS
h
MW
PW
= = = = =
- - -


B.
Extreme outcome #1: 75 . 9 S
PW
= and 18 F
MW
=

Purchase at spot: (100,000)(9.75) = 975,000
Gain on futures: (5)(10,000)(18 12.50) = 275,000
Net cost: 975,000 275,000 = 700,000

Extreme outcome #2: 75 . 3 S
PW
= and 6 F
MW
=

Purchase at spot: (100,000)(3.75) = 375,000
Gain on futures: (5)(10,000)(6 12.50) = 325,000
Net cost: 375,000 + 325,000 = 700,000






Question 7

Hector Lopez is a bond portfolio manager at PNY. His portfolio has a market value of $500
million and a duration of 9.8 years. Answer the following questions.

A. Compute an estimate for the percentage change in the value of the portfolio if interest rates
decrease by 50 basis points. Use the formula that assumes continuous compounding.
Compute an estimate for the market value of the portfolio after the decrease in interest rates?

B. Mr. Lopez would like to use T-bond futures to hedge the risk of an increase in interest rates.
He decides to use the September contract, which has a futures price quote of 96-22
(96+22/32). The duration of the cheapest-to-deliver bond for the September contract is
expected to be 8.7 years, and he estimates that the average duration of his portfolio by
September will be 9.6 years. What position must he establish (long or short) and why? How
many contracts must this position have to achieve a minimum variance hedge? Assume the
market value of the portfolio is $500 million.

C. Suppose that after setting up this hedged position interest rates increase by 75 basis points.
Show that the decrease in the bond portfolio is offset by the gain on the T-bond futures
position. The September T-bond futures price decreases to 90-12 (96+12/32), and the bond
portfolios average duration is 9.6 years. As in part A, use the continuous compounding
formula.

Solution:

A. 049 . 0 ) 005 . 0 )( 8 . 9 ( y D
B
B
= = A =
A


Portfolio value = (1.049)($500 million) = $524,500,000

B. Short: Both the portfolio value and T-bond futures price decrease as interest rates increase.
He must establish a short position to make money on the futures position to offset the
decrease in the value of the portfolio.

26 . 706 , 5
) 7 . 8 )( 5 . 687 , 96 (
) 6 . 9 )( 000 , 000 , 500 (
D F
D S
N
F
S
= = =
-
or 5,706 contracts

C. Change in Value of Portfolio:

000 , 000 , 36 ) 000 , 000 , 500 )( 0075 . 0 )( 6 . 9 ( ) S )( y )( D ( S
S
= = A = A

Change in Futures Position: 125 , 019 , 36 ) 375 , 90 5 . 687 , 96 )( 706 , 5 ( F = = A



Question 8

Michael Johnson made delivery on his short position in five December T-bond futures contracts
on Wednesday, December 13, 2006. Using the information below, compute the cash that
Michael received on the delivery day.

December T-bond futures settlement prices
Monday, December 11, 2006 110-07
Tuesday, December 12, 2006 110-15
Wednesday, December 13, 2006 110-23
Thursday, December 14, 2006 111-01
Friday, December 15, 2006 110-30

Available T-bonds to deliver
Bond Coupon (%) Quoted Price Maturity CF
1 7.00 109-05 Nov. 15, 2022 1.1156
2 6.00 108-23 Nov. 15, 2023 1.0000
3 6.50 109-15 Nov. 15, 2025 1.0623
4 7.50 110-02 Nov. 15, 2026 1.1812

Day counts
Time Period Number of Days
Nov. 15, 2006 to Dec. 11, 2006 26
Nov. 15, 2006 to Dec. 12, 2006 27
Nov. 15, 2006 to Dec. 13, 2006 28
Nov. 15, 2006 to Dec. 14, 2006 29
Nov. 15, 2006 to Dec. 15, 2006 30
Nov. 15, 2006 to May 15, 2007 181

Solution:
For one contract, the cash received by the short is

Cash = (Settlement contract price on position day)(CF) + Accrued interest

Position day = Monday, December 11

Settlement price on position day = 110-07 or 110.21875

Contract price = (100,000/100)(110.21875) = $110,218.75

Find the cheapest-to-deliver T-bond:
Quoted price (Quoted futures price on position day)(CF)
1 109.15625 (110.21875)(1.1156) = 13.8038
2 108.71875 (110.21875)(1.0000) = 1.5000
3 109.46875 (110.21875)(1.0623) = 7.6166
4 110.06250 (110.21875)(1.1812) = 20.1279 Cheapest-to-deliver

Accrued interest for cheapest-to-deliver bond:
Nov. 15, 2006 to Dec. 13, 2006 = 28 days
Nov. 15, 2006 to May 15, 2007 = 181 days
For one bond: (100,000)(0.075/2)(28/181) = $580.11

The cash received by Michael for 5 contracts is therefore equal to

Cash = 5 {110,218.75 1.1812 + 580.11} = $653,852.49






















Question 9
Intelilogic Inc. enters into a $50 million notional principal swap in which it agrees to pay fixed
and receive LIBOR. Payments will be made every six months with the floating payments based
on LIBOR six months prior. The swap lasts for two years. For simplicity, assume there are
exactly 180 days in a six-month period and 360 days in a year. Answer the following questions.

A. What is the swap rate that sets the value of the swap equal to zero at the onset? The current
LIBOR term structure is as follows.
LIBOR Rates with Semiannual Compounding
Maturity LIBOR (%)
6 month 6.0
1 year 6.5
18 month 7.0
2 year 7.5

B. Suppose that Intelilogic is exactly one year into the life of the swap. On the last payment
date (today), LIBOR is 8.00% per year with semiannual compounding. Currently, the 1-year
LIBOR rate is 8.5% per year with semiannual compounding. Compute the value of the swap
from Intelilogics perspective.

Solution:
A.
4 3 2 1
2
075 . 0
1
000 , 000 , 50 Coupon
2
07 . 0
1
Coupon
2
065 . 0
1
Coupon
2
06 . 0
1
Coupon
000 , 000 , 50
|
.
|

\
|
+
+
+
|
.
|

\
|
+
+
|
.
|

\
|
+
+
|
.
|

\
|
+
=

Coupon = 1,863,495.482

Swap Rate = 074539819 . 0
000 , 000 , 50
482 . 495 , 863 , 1
2 = |
.
|

\
|

B. Fixed payment = 1,863,495.482

Floating payment = 50,000,000(0.08/2) = 2,000,000

85 . 835 , 512 , 49
2
085 . 0
1
482 . 495 , 863 , 51
2
08 . 0
1
482 . 495 , 863 , 1
B
2 1
fixed
=
|
.
|

\
|
+
+
|
.
|

\
|
+
=

000 , 000 , 50
2
08 . 0
1
000 , 000 , 50
2
08 . 0
1
000 , 000 , 2
B
1 1
float
=
|
.
|

\
|
+
+
|
.
|

\
|
+
= (as expected!)

15 . 164 , 487 $ B B V
fixed float swap
= =
Question 10

Consider the lower bound for a European put on a non-dividend-paying stock:

| | 0 ), t ( S ) T , t ( XB Max ) T , t , X , S ( p >

Answer the following questions.

A. Prove that there will be an arbitrage opportunity if the lower bound is violated. Use the
following arbitrage table in your proof.



Transaction

Payoff at t

Payoff at T


























B. Prove that | | 0 )) T ( S X ( 0 ), T ( S X Max > .

C. Why doesnt the lower bound in A. also hold for American puts?
















Solution:

A.


Transaction

Payoff at t

Payoff at T

Buy put

Buy stock

Borrow XB

p

S

+XB

Max[X S(T), 0]

S(T)

X

Sum

XB S p > 0

Max[X S(T), 0] (X S(T)) > 0


Arbitrage:


0 p S XB S XB p
buy
buy borrow
> <

B.
If S(T) < X: X S(T) (X S(T)) = 0

If S(T) > X: 0 (X S(T)) = S(T) X > 0

Therefore | | 0 )) T ( S X ( 0 ), T ( S X Max > .


















Question 11

You decide to use a collar option strategy on Cisco Systems, Inc. You plan to purchase 1,000
shares of Cisco and simultaneously establish a long put option position in 10 contracts and a
short call option position in 10 contracts. The current price of Cisco is $65 per share. The put
options have an exercise price of $55, a maturity of 3 months, and are priced at $1.50 per option.
The call options have an exercise price of $80, a maturity of 3 months, and are priced at $1.00
per option. Answer the following questions.

A. Complete the following table. For the purpose of filling in the table, assume one share of
stock, one put option, and one call option.





Position




Now (t)

Expiration (T)























































Net










B. Graph the profit of the position in A. as a function of S(T).

C. What other option strategy has a profit graph similar to that in B?

D. Compute the maximum gain, maximum loss and breakeven price of the strategy. The
maximum gain and loss should be based on 1,000 shares, 10 put contracts, and 10 call
contracts.

E. Compute the standstill return of the strategy. The standstill return should be based on 1,000
shares, 10 put contracts, and 10 call contracts.




Solution:

A.





Position




Now (t)

Expiration (T)


S(T) < 55


55 s S(T) < 80

S(T) > 80


Long Stock


Long Put


Short Call



65


1.50


+ 1.00


S(T)


55 S(T)


0


S(T)


0


0


S(T)


0


(S(T) 80)

Net


65.50

55

S(T)

80

B. Your profit graph should look like that for a bull call (put) spread.

C. Bull call (put) spread.

D.
Maximum gain: (1,000)(80 65.50) = $14,500

Maximum loss: (1,000)(55 65.50) = $10,500

Breakeven price: (1,000)(S(T) 65.50) S(T) = $65.50

E.
S(T) = S = 65
(1000)[S + Max(XP S, 0) Max(S XC, 0) (S + P C)]
(1000)[65 + 0 0 65 1.50 + 1.00]
(1000)[ 0.50]
$500

Question 12

Consider a six-month put option with a strike price of 60 on a stock whose current price is 60.
There are two time steps of three months and in each time step the stock price either moves up
by 15% or down by 20%. The risk free rate of interest is 5.5% per year with continuous
compounding.

A. Compute the value of a European put option.

B. Compute the value of an American put option.

C. Compute the value of the right of early exercise.

Solution:

A. 389 . 0 ) p 1 ( and 611 . 0
80 . 0 15 . 1
80 . 0 e
d u
d e
p
) 25 . 0 )( 055 . 0 ( t r
= =

=
A


( ) 84170 . 1 ) 8 . 4 )( 389 . 0 ( ) 0 )( 611 . 0 ( e P
) 25 . 0 )( 055 . 0 (
u
= + =



( ) 18041 . 11 ) 6 . 21 )( 389 . 0 ( ) 8 . 4 )( 611 . 0 ( e P
) 25 . 0 )( 055 . 0 (
d
= + =



( ) 3997 . 5 ) 18041 . 11 )( 389 . 0 ( ) 84170 . 1 )( 611 . 0 ( e P
) 25 . 0 )( 055 . 0 (
Euro
= + =



B. Up state in three months: max(60 69, 1.84170) = 1.84170

Down state in three months: max(60 48, 11.18041) = 12

( ) 7142 . 5 ) 12 )( 389 . 0 ( ) 84170 . 1 )( 611 . 0 ( e P
) 25 . 0 )( 055 . 0 (
Amer
= + =



C. 3145 . 0 3997 . 5 7142 . 5 P P
Euro Amer
= =













Question 13

The Dallas/Fort Worth International Airport would like to buy the option to purchase a large
parcel of land on the edge of the city of Grapevine from a real estate investor. The option would
give the airport the right to buy the land in one year for $10 million. Real estate experts estimate
that the land will be worth either $12 million or $8 million in one year. The current value of the
land is $9.5 million. If the risk-free rate of interest is 5% per year with continuous compounding,
what is the fair market value of the option?

Solution:

Riskless Hedge Portfolio Approach:

t = 0: Form the portfolio: C ) 5 . 9 )( ( A

t = 1: Set the up and down values of the portfolio equal and solve for A:

50 . 0 0 ) 8 )( ( ) 10 12 ( ) 12 )( ( = A A = A

Equate t = 0 value of portfolio to certain discounted value and solve for C:

94508230 . 0 $ C e 4 C ) 5 . 9 )( 50 . 0 (
) 1 )( 05 . 0 (
= =

million or $945,082.30

Risk-Neutral Valuation Approach:

| |
) 1 )( 05 . 0 (
e ) 8 )( p 1 ( ) 12 )( p ( 5 . 9

+ =

p = 0.496768853 and (1 p) = 0.503231146


| |
) 1 )( 05 . 0 (
e ) 0 )( 503231146 . 0 ( ) 10 12 )( 496768853 . 0 ( C

+ =

C = $0.94508230 million or $945,082.30











Question 14

Sally Shoomaker is a market maker in options on ADP. She currently has a large inventory of
three month call options on ADP and would like to create a delta and gamma neutral position
using the one-month call option on ADP and the six-month put option on ADP. The delta and
gamma parameters for the one-month call option (
1
C ), the three-month call option (
3
C ), and the
six-month put option (
6
P ) are as follows.

Price Delta Gamma
232 . 4 C
1
= 537 . 0
1 C
= A 039 . 0
1 C
= I
568 . 7 C
3
= 563 . 0
3 C
= A 023 . 0
3 C
= I
541 . 8 P
6
= 411 . 0
6 P
= A 016 . 0
6 P
= I

For each three month call option held long, find the corresponding positions in the one-month
call option and the six-month put option so that the overall position is delta and gamma neutral.
Then show that your position is both delta neutral and gamma neutral for small changes in the
stock price of ADP.

Solution:


6 P 1 C 3
P x C x C + = H

0 x x
S
6 P P 1 C C 3 C
= A + A A =
c
H c
(1)

0 x x
S
6 P P 1 C C 3 C
2
2
= I + I I =
c
H c
(2)

From (1) we may determine that
1 C
6 P
P
1 C
3 C
C
x x
A
A
+
A
A
= . Substituting this expression into (2) and
solving for
P
x gives

1 C 6 P 6 P 1 C
3 C 1 C 1 C 3 C
P
x
I A I A
I A I A
=

Substituting this expression for
P
x into
1 C
6 P
P
1 C
3 C
C
x x
A
A
+
A
A
= gives

1 C 6 P 6 P 1 C
3 C 6 P 6 P 3 C
C
x
I A I A
I A I A
=

From these expressions for
P
x and
C
x we may determine that

39 . 0 390155 . 0
024621 . 0
009606 . 0
) 039 . 0 )( 411 . 0 ( ) 016 . 0 )( 537 . 0 (
) 023 . 0 )( 537 . 0 ( ) 039 . 0 )( 563 . 0 (
x
P
~ = =

=

75 . 0 749807 . 0
024621 . 0
018461 . 0
) 039 . 0 )( 411 . 0 ( ) 016 . 0 )( 537 . 0 (
) 023 . 0 )( 411 . 0 ( ) 016 . 0 )( 563 . 0 (
x
C
~ = =


=

6 1 3
P ) 39 . 0 ( C ) 75 . 0 ( C + = H

We now check whether the overall position is delta neutral and gamma neutral:

Delta Neutral 0 ) 411 . 0 )( 39 . 0 ( ) 537 . 0 )( 75 . 0 ( 563 . 0
S
= + =
c
H c


Gamma Neutral 0 ) 016 . 0 )( 39 . 0 ( ) 039 . 0 )( 75 . 0 ( 023 . 0
S
2
2
= + =
c
H c


Question 15

Consider an option on a non-dividend-paying stock when the stock price is $56, the exercise
price is $50, the risk-free interest rate is 5 percent per year with continuous compounding, the
volatility is 30 percent per year, and the time to maturity is three months. Answer the following
questions. Note: To compute standard normal probabilities (e.g., ) d ( N
1
and ) d ( N
2
), students
were given the standard normal probability tables or they have TI-83.

A. What is the price of the option if it is a European call?

B. What is the price of the option if it is an American call?

C. What is the price of the option if it is a European put?

D. Verify that put-call parity holds.

E. Now assume that the stock pays dividends and that it is expected to go ex-dividend in 1.5
months. The dividend is expected to be $0.50 per share. What is the price of the option if it
is a European put?






Solution:
A.
9139 . 0
25 . 0 ) 30 . 0 (
) 25 . 0 )( 2 / ) 30 . 0 ( 05 . 0 ( ) 50 / 56 ln(
T
T ) 2 / r ( ) X / S ln(
d
2 2
1
=
+ +
=
o
o + +
=

7639 . 0 25 . 0 ) 30 . 0 ( 9139 . 0 T d d
1 2
= = o =


) d ( N
1
= N(0.9139) = N(0.91) + (0.39)[N(0.92) N(0.91)]

= 0.8186 + (0.39)[0.8212 0.8186]

= 0.81961

) d ( N
2
= N(0.7639) = N(0.76) + (0.39)[N(0.77) N(0.76)]

= 0.7764 + (0.39)[0.7794 0.7764]

= 0.77757

50 . 7 ) 77757 . 0 ( e ) 50 ( ) 81961 . 0 )( 56 ( ) d ( N Xe ) d ( SN C
25 . 0 05 . 0
2
rT
1
= = =



B. C = 7.50

C.
) d ( N
1
= ) d ( N 1
1


= 1 0.81961

= 0.18039

) d ( N
2
= ) d ( N 1
2


= 1 0.77757

= 0.22243

88 . 0 ) 18039 . 0 )( 56 ( ) 22243 . 0 ( e ) 50 ( ) d ( SN ) d ( N Xe P
25 . 0 05 . 0
1 2
rT
= = =



D.
rT
Xe S P C

=

25 . 0 05 . 0
e 50 56 88 . 0 50 . 7

=

6.62 = 6.62

E.
4969 . 0 e ) 50 . 0 ( ) D ( PV
125 . 0 05 . 0
= =



5031 . 55 ) D ( PV S S = =
-


8544 . 0
25 . 0 ) 30 . 0 (
) 25 . 0 )( 2 / ) 30 . 0 ( 05 . 0 ( ) 50 / 5031 . 55 ln(
T
T ) 2 / r ( ) X / S ln(
d
2 2
1
=
+ +
=
o
o + +
=

7044 . 0 25 . 0 ) 30 . 0 ( 8544 . 0 T d d
1 2
= = o =