Investments, tenth edition

   PROBLEM SETS 

S

T

0

Rate of Return

Price of Stock 6 Months from Now

$80

$100

$110

$120

a. All stocks (100 shares)

b. All options (1,000 shares)

c. Bills 1 100 options

   7.  The common stock of the P.U.T.T. Corporation has been trading in a narrow price range for the 

past month, and you are convinced it is going to break far out of that range in the next 3 months. 

You do not know whether it will go up or down, however. The current price of the stock is $100 

per share, and the price of a 3-month call option at an exercise price of $100 is $10.

a.   If the risk-free interest rate is 10% per year, what must be the price of a 3-month put option on 

P.U.T.T. stock at an exercise price of $100? (The stock pays no dividends.)  

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712 

P A R T   V I

  Options, Futures, and Other Derivatives

    b.   What would be a simple options strategy to exploit your conviction about the stock price’s 

future movements? How far would it have to move in either direction for you to make a 

profit on your initial investment?     

    8.  The common stock of the C.A.L.L. Corporation has been trading in a narrow range around $50 

per share for months, and you believe it is going to stay in that range for the next 3 months. The 

price of a 3-month put option with an exercise price of $50 is $4.

     a.   If the risk-free interest rate is 10% per year, what must be the price of a 3-month call option 

on C.A.L.L. stock at an exercise price of $50 if it is at the money? (The stock pays no 

dividends.)  

    b.   What would be a simple options strategy using a put and a call to exploit your conviction 

about the stock price’s future movement? What is the most money you can make on this 

position? How far can the stock price move in either direction before you lose money?  

    c.   How can you create a position involving a put, a call, and riskless lending that would have 

the same payoff structure as the stock at expiration? What is the net cost of establishing that 

position  now?     

    9.  You are a portfolio manager who uses options positions to customize the risk profile of your 

clients. In each case, what strategy is best given your client’s objective?

     a.       

•

   Performance to date: Up 16%.  

     • 

 Client objective: Earn at least 15%.  

     • 

 Your scenario: Good chance of large gains or large losses between now and end of year.

    

i.  Long  straddle.  

   

ii.  Long  bullish  spread.  

   

iii.  Short  straddle.        

     b.    

•

      Performance to date: Up 16%.  

     • 

 Client objective: Earn at least 15%.  

     • 

 Your scenario: Good chance of large losses between now and end of year.

    

i.  Long  put  options.  

   

ii.  Short  call  options.  

   

iii.  Long  call  options.           

   10.  An investor purchases a stock for $38 and a put for $.50 with a strike price of $35. The inves-

tor sells a call for $.50 with a strike price of $40. What is the maximum profit and loss for this 

position? Draw the profit and loss diagram for this strategy as a function of the stock price at 

expiration.  

   11.  Imagine that you are holding 5,000 shares of stock, currently selling at $40 per share. You are 

ready to sell the shares but would prefer to put off the sale until next year for tax reasons. If 

you continue to hold the shares until January, however, you face the risk that the stock will drop 

in value before year-end. You decide to use a collar to limit downside risk without laying out 

a good deal of additional funds. January call options with a strike of $35 are selling at $2, and 

January puts with a strike price of $45 are selling at $3. What will be the value of your portfolio 

in January (net of the proceeds from the options) if the stock price ends up at: ( a ) $30, ( b )  $40, 

or ( c ) $50? Compare these proceeds to what you would realize if you simply continued to hold 

the shares.  

   12.  In this problem, we derive the put-call parity relationship for European options on stocks that 

pay dividends before option expiration. For simplicity, assume that the stock makes one divi-

dend payment of $ D  per share at the expiration date of the option.

     a.   What is the value of a stock-plus-put position on the expiration date of the option?  

    b.   Now consider a portfolio comprising a call option and a zero-coupon bond with the same 

maturity date as the option and with face value ( X   1   D ). What is the value of this portfolio 

on the option expiration date? You should find that its value equals that of the stock-plus-put 

portfolio regardless of the stock price.  

    c.   What is the cost of establishing the two portfolios in parts ( a ) and ( b )? Equate the costs of 

these portfolios, and you will derive the put-call parity relationship, Equation 20.2.     

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  C H A P T E R  

2 0

  Options Markets: Introduction 

713

   13.      a.    A butterfly spread is the purchase of one call at exercise price  X  

1

 , the sale of two calls at 

exercise price  X  

2

 , and the purchase of one call at exercise price  X  

3

 .  X  

1

  is less than  X  

2

 ,  and 

 X  

2

  is less than  X  

3

  by equal amounts, and all calls have the same expiration date. Graph the 

payoff diagram to this strategy.  

    b.   A vertical combination is the purchase of a call with exercise price  X  

2

  and a put with exercise 

price  X  

1

 , with  X  

2

  greater than  X  

1

 . Graph the payoff to this strategy.     

   14.  A bearish spread is the purchase of a call with exercise price  X  

2

  and the sale of a call with 

exercise price  X  

1

 , with  X  

2

  greater than  X  

1

 . Graph the payoff to this strategy and compare it to 

 Figure 20.10 .  

  15.  Joseph Jones, a manager at Computer Science, Inc. (CSI), received 10,000 shares of company 

stock as part of his compensation package. The stock currently sells at $40 a share. Joseph 

would like to defer selling the stock until the next tax year. In January, however, he will need to 

sell all his holdings to provide for a down payment on his new house. Joseph is worried about 

the price risk involved in keeping his shares. At current prices, he would receive $400,000 for 

the stock. If the value of his stock holdings falls below $350,000, his ability to come up with the 

necessary down payment would be jeopardized. On the other hand, if the stock value rises to 

$450,000, he would be able to maintain a small cash reserve even after making the down pay-

ment. Joseph considers three investment strategies:

     a.   Strategy A is to write January call options on the CSI shares with strike price $45. These 

calls are currently selling for $3 each.  

    b.   Strategy B is to buy January put options on CSI with strike price $35. These options also sell 

for $3 each.  

    c.   Strategy C is to establish a zero-cost collar by writing the January calls and buying the 

January puts.    

    Evaluate each of these strategies with respect to Joseph’s investment goals. What are the advan-

tages and disadvantages of each? Which would you recommend?

   16.  Use the spreadsheet from the Excel Application boxes on spreads and straddles (available at 

  www.mhhe.com/bkm   ;  link to Chapter 20 material) to answer these questions.

     a.   Plot the payoff and profit diagrams to a straddle position with an exercise (strike) price of 

$130. Assume the options are priced as they are in the Excel Application.  

    b.   Plot the payoff and profit diagrams to a bullish spread position with exercise (strike) prices 

of $120 and $130. Assume the options are priced as they are in the Excel Application.     

   17.  Some agricultural price support systems have guaranteed farmers a minimum price for their 

output. Describe the program provisions as an option. What is the asset? The exercise price?  

   18.  In what ways is owning a corporate bond similar to writing a put option? A call option?  

   19.  An executive compensation scheme might provide a manager a bonus of $1,000 for every dollar 

by which the company’s stock price exceeds some cutoff level. In what way is this arrangement 

equivalent to issuing the manager call options on the firm’s stock?  

   20.  Consider the following options portfolio. You write a January expiration call option on IBM 

with exercise price $195. You write a January IBM put option with exercise price $190.

     a.   Graph the payoff of this portfolio at option expiration as a function of IBM’s stock price at 

that time.  

    b.   What will be the profit/loss on this position if IBM is selling at $198 on the option expiration 

date? What if IBM is selling at $205? Use  The Wall Street Journal  listing from  Figure 20.1  

to answer this question.  

    c.   At what two stock prices will you just break even on your investment?  

    d.   What kind of “bet” is this investor making; that is, what must this investor believe about 

IBM’s stock price to justify this position?     

   21.  Consider the following portfolio. You write a put option with exercise price 90 and buy a put 

option on the same stock with the same expiration date with exercise price 95.

     a.   Plot the value of the portfolio at the expiration date of the options.  

    b.   On the same graph, plot the profit of the portfolio. Which option must cost more?