Examples for Option: Ex. 1. The stock price 6 months from the expiration of an option is $42, the exercise price of the option $340, the risk free interest rate is 10% per annum and the volatility is 20% per annum. This means that Sy=42, K= 40, 20.1, 0-0.2, T=0.5 =n (42/40) + (0.1 +0.28/2)K0.5_+0.7693 0.2v05 dy=4n 42/40) + (0.1 -0.22/2):0.5 o.2v05 And ke-'T= 40e~995=38.049 Hence , ifthe option isa European call, its value cis given by = 42N (0.7693) ~38,049N(0.6278) Ifthe option is European put, its value pis given by p=38.049N( -0.6278) — 42N (-0.7693) Using the polynomial expression just given or the NORMSDIST function in Excel N (0.7693) =0.7791, N(-0.7693)=0.2209 1N(0.6278)=0.7349, N(-0.6278)=0.2651 So that, 76, Ignoring the time value of money, the stock price has to rise by $2.76 for the purchaser of the call to breakeven. Similarly, the stock price has to fall by $2.81 for the purchaser of the put to break even,Ex. 2. Consider a European call option on a stock when there are ex-dividend dates in two months and five months. The dividend on each ex-dividend date is expected to be $0.50. The current share price is $40, the exercise price is $40, the stock price volatility is 30% per annum, the risk free rate of interest is ‘9% per annum, and the time to maturity is six months. The present value of the dividend is: Ose 09 + 0,5e-04167*0.09_ 9.9741 The option price can therefore be calculated from the Black-Scholes Formula, with So =40-0.9741=39.0259 , K=40, 10.09 , 0=0.3 and 1-05 ,=1n (39.0259/40) + (0.09 + 0.32/2)x0.5 0.2017 0.305 d,=1n (39.0259/40) + (0.0 9 - 0.32/2 03v05 Using the polynomial expression in section 13.9 or the NORMSDIST function in 5800 , Nd Nay And from the equation (13.20), the call price is, 3.67 or $3.67 39,0259 x 0.5800 - 40e~%99*95 0.4959Bx > Calculate the price ofa 3-month European put option on a non-dlvidend paying stock witha strike Beco a tan the current stock price(s $50, the rik- free interest rate i 10%per annuny and the volatility is 30%per annum, Ex 4. What's the price of a European call option on a non-dividend-paying stock when the stock price is $52, the strike price is $50, the risk-free interest rate is 12%per annum, the voltlity is 30%per annum ‘and the time to maturity is 3 months? Ex, What is the price of a European put option on a non-dividend-paying stock when the stock price s $69, the strike price is $70, the risk free interest rate is S%per annum, the volatility is 35%per annum and the time to maturity is 6 months? EX6.A call option on a non-dividend-paying stock has a market price of $21/?, The stock price is $15, the exercise price is $13, the time to maturity is 3 months, and the risk free interest rate is 5%per annum. What is the implied volatility?4 ‘GAINS /LOSSES FROM FORWARD HEDGE RECEIPTS FROM THE BRITISH SALE SPOTEXCHANE RATE | UNHEDGED POSITION | FORWARD HEDGE | GAIN/LOSSES FROM ON MATURITY DATE | HEDGE $1.60 [16,000,000 $14,600,000 -$1,4000,000 Qi. Assume that the spot exchange rate is $1.60per £ on the maturity date of the contract a) Suppose that in the over the counter market Boeing purchased a put option on 10 million British £ with an exercise price of $1.46 and a one year expiration. Assume that the option premium (price) is 0.02 per£. How much will Boeing pay? Soln: Boeing thus paid $0.02%10 million =$2,00,000. , This transaction provides Boeing with the right but not the obligation to sell up to £10 million for ; $1.46/€ , regardless of the future spot rate. b) If the spot exchange rate is $1.30 on the expiration date. | Soln: Since Boeing has the right to sell $1.46, it will certainly exercise its put option on the fand convert £10 million into $4.46 million. i) Now, Boeing paid $2,00,000 upfront for the option and considering the time value of money, i this upfront cost is: '$2,00,000x1,061 = $212,200 as of expiration date. This means that under option hedge, the net $ proceeds from the British sale becomes; ‘$14,600,000- $212,200=$14,387,800 Since Boeing is going to exercise its put option on the pound whenever the future spot exchange rate falls below the exercise rate of $1.46, itis assured of a “minimum” dollar receipt of $14,387,800 from the British sale. .2.(a)Suppose Boeing imported a Rolls-Royce jet engine for £5 million payable in one year with the following market condition: The U.S interest rate 6.00% per annum The U.K interest rate 6.50% per annum ‘The spot exchange rate $1.80/£ ‘The forward exchange rate _| $1.75/E(1-year maturity) If Boeing decides to hedge this payable exposure using a forward contract, it needs to buy £5On the maturity date of the forward contract , Boeing will receive £5,000,000 from the counter par the contract in exchange for $8,750,000. Boeing can use 5,000,000 to make payment to Rolls ~Royc Since Boeing will have £5,000,000 for sure in exchange for a given dollar amount, that is, $8,750,000 fegardiless for the spot exchange rate that may prevail in one year, Boeing's foreign currency payable fully hedged (b) ifthe British pound appreciates against the dollar beyond $1.80/€, the strike price of the option contract }© exercise its options and purchase £5,000,000 for $9,000,000 i.e £5,000,000x$1.80/£=$9,000,000 (c)if Boeing decides to use currency options contract to hedge its pound payable, it needs to buy “call ptions on £5,000,000. Boeing will have to decide on the exercise and strike price for the call options. We assume that Boeing chooses the exercise price of $1.80/E with a premium of $0.018 per pound. What would be the total cost of options as of maturity date (considering the time value Soln: $0.018£5,000,000%1.06-$95,4 (d) if the spot rate on the maturity date turns out to be below its strike price Soin: Boeing will let the option expire and purchase the pound amount in the spot market. Thus will be able to secure £5,000,000 for a maximum of $9,0: $9,000,000+595,000-$9,095,400Q3: Suppose that the variance of daly returns of a security with B= 1.2, is 8.2. Further, the standard Geviation of dally returns of an index is 1.7. Calculate the magnitude of risk reduction which complete hhedging will achieve and the risk faced by the investor with hedging, Soln : Total risk, var (kj)=8.2 Market risk, 6)? var (ky) = (1.2)2(1.7; 616 Thus, the risk reduction by hedging = 4.1616 and risk faced by investor, non-market risk 8.2-4.1616- 4.0384 G4. A call option involving 200 shares , due to mature, i selling for Rs 3.25 on a share which is seling at the market at Rs.66. The option has an exercise price equal to Rs.62. Calculate the net profit. Soln: Here, the call price is lower than its intrinsic value. An arbitrageur may buy the call for 200 shares by paying Rs.650 (200x3.25), exercise it and get the shares by paying Rs.12,400. The 200 shares may be sold immediately in the market to get Rs.13,200. Hence, it would yield a net profit Rs.13,200 - Rs. 12,400 - Rs.650 = Rs.150. Q5. Suppose that a call option involving 100 shares is selling for Rs.5.25 when the share price is Rs.64 and exercise price is Rs.60. Calculate the profit. Soln: here, an arbitrageur can sell the call on 100 shares to receive Rs.525 and buy the shares for Rs.6400. When the call, being in-the- money , is exercised, shares can be delivered for Rs.6000. This would result in an arbitrage profit of 5.6,000+ Rs.525 ~ Rs.Rs.6400 = Rs.125, S,,and the Thus, the price of a call on expiration isa function of the share price at the expiration exercise price, E This is equal to 0 when SE and S,-€ when S,>E.‘a beta value of 1.17. Suppose that the spot index i Q6. The manager has a portfolio of Rs.2 lacs, w 1120 and the future price is Rs.1125. Further the future contract has a multiple of 50. How can you use the stock index futures if (a) The portfolio beta is decreased to 0.9 (b) The portfolio beta is increased to 1.5, Soln: 1.17 t0 0.8, the portfolio manager may sell off a portion of (a) To decrease the portfolio beta from isk: less securities. if we let the existing portfolio as asset equities and use the proceeds to buy and the risk-less security as asset 2, we have, By=01By ot; 10;f;+(1— :)B2_ (since the new portfolio consist of only two assets) xisting portfolio or 0.9 ( the desired portfolio beta), fy=1.17(the beta value of the We have fi, is being a risk-less asset) asset 1) and f. Substituting the known values we get; 0.921; x 1.17 @-«,)0 w, = 0.76923 This implies that a portfolio consisting of Rs.15.3846 lacs , 0.76923 times Rs.20 lacs , invested in three securities as given above and Rs.20 lacs - Rs.15.3846 lacs = Rs.4.6154 lacs in risk-less securities (T-bills) would have a beta of 0.9, Alternatively the manager can sell stock index futures contracts no.of units of spot position requiring hedging Number of future contracts to trade=hx a no.of units underlyimg one futures contract Here we may beta of the portfolio to serve as h* and take the ratio of the monetary value (rupee value) Of the spot position to be hedged, and the monetary value of the spot index. cau Rupee value of the spot position to be hedged Rs. 4.6154 lacs Rupee value of one year futures contract = index valuex multiplier 112050=Rs.56,000=R5.0.56 lacsNumber of futures contra a from 1.17 to0.9 iets required to change portfolio be = 1.17x4.6154/0.56=9. ‘Thus instead of selling Rs.4.6154 lacs ofthe risky equity portfolio, the manager can reduce the beta t 0.9 by selling 9.643 (10) stock index fut equity stock portfolio by selling the required number of futures to hedge Rs.5.40 lacs of that portfolio. es . The manager may therefore continue to own the Rs20 lacs (b) To increase the portfolio beta from 1.17 to 1.50: Soln: By = B,4(1 — w,)) 15 = @4x1.17 + (1 ~ @1)0 , = 1.28205 This implies shorting the risk-less asset T-bills with a market value of 0.28205x20=Rs.5.641 lacs, So that the total investment in the portfolio of three securities be Rs.25.641 lacs and Rs.5.641, lacs is borrowed. The aim of increasing beta to 1.5 can be achieved alternatively by buying stock index future contracts equivalent to Rs.5.641lacs. Therefore, Number of future contracts required to change portfolio beta from 1.17 to 1,50=1.17%5,641/0.56=11.786. rS