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INTRODUCTION TO FINANCIAL OPTIONS

Aix-en-Provence, April 2016

Report all the necessary computations.

Exercises solved only partially will be corrected anyway.
Little credit will be given to fragmentary answers.
If necessary, make additional assumptions on possible missing data; in this case, express
clearly the assumptions you make.
Use the space below each question to report the solution of the exercises. When necessary,
add pages.

1. The spot price of one share of stock il 20. The risk-free interest rate (continuously compounded) is 4 % per annum. Consider a put option written on this stock, with exercise
price 20. Compute an upper bound for the price of the put option both in the American
and European case.
Consider the European style put option with strike price K. Show that when the upper bound is violated, there are some arbitrage opportunities. Explain in detail possible
arbitrage strategies.

2. A European call option with maturity 3 months, written on a stock which does not pay
dividends, is quoted 2.57 euro. The underlying stock price is e32.12, and the strike price is
e30. Given that the risk-free interest rate (continuously compounded) is 2 % per annum,
discuss possible arbitrages.

3. Consider a European put option written on the same underlying as in the previous exercise
and same maturity, but with strike price e33.84. The option is currently quoted at 1.64
euro. Given that the risk-free interest rate (continuously compounded) is 2 % per annum,
discuss possible arbitrages.

4. A European call option with maturity 3 months, written on a stock which does not pay
dividends, is quoted 2.34 euro. A European put option written on the same underlying,
same maturity, and same strike price is quoted 1.65. Given that the risk-free interest rate
(continuously compounded) is 2 % per annum, discuss possible arbitrages.

5. Given the options as in the previous exercises. Discuss possible trading strategies (e.g.
covered call writing, spreads, etc.). Draw the payo and prot and loss diagrams of such
strategies.