FINM7041 Applied Derivatives

Tutorial 4 Solutions
Question One
Explain why an American option is always worth at least as much as a European
option on the same asset with the same strike price and exercise date.

Question Two
Suppose that sterling-US dollar spot and forward exchange rates are as follows:
Spot
1.8470
90-day forward
1.8381
180-day forward
1.8291
What opportunities are open to an investor in the following situations?
a. A 180-day European call option to buy 1 for $1.80 costs $0.0250.
b. A 90-day European put option to sell 1 for $1.86 costs $0.0200.

Question Three
The price of European call that expires in six months and has a strike price of $30 is
$2. The underlying stock price is $29, and a dividend of $0.50 is expected in two
months and again in five months. The term structure is flat, with all risk-free interest
1

rates being 10%. What is the price of a European put option that expires in six
months and has a strike price of $30?

Question Four
Suppose that put options on a stock with strike prices $30 and $35 costs $4 and $7,
respectively. How can the options be used to create (a) a bull spread and (b) a bear
spread? Construct a table that shows the profit and payoffs for both spreads.

Question Five
Use put-call parity to show that the cost of a butterfly spread created from European
puts is identical to the cost of a butterfly spread created from European calls.

Question Six
A call with a strike price of $60 costs $6. A put with the same strike price and
expiration date costs $4. Construct a table that shows the profit from the straddle.
For what range of stock prices would the straddle lead to a loss.