Principles of Finance

HEC Lausanne Solution 7 December 2, 2019

Problem 1
You are long two calls on the same share of stock with the same exercise date. The exercise
price of the first call is $40 and the exercise price of the second call is $60. In addition, you
are short two otherwise identical calls, both with an exercise price of $50. Plot the value of
this combination as a function of the stock price on the exercise date. What is the name of
this combination of options?

Solution
This is called a Butterfly Spread.

Problem 2
The current price of Estelle Corporation stock is $25. In each of the next two years, this
stock price will either go up by 20% or go down by 20%. The stock pays no dividends. The
one-year risk-free interest rate is 6% and will remain constant. Using the Binomial Model,
calculate the price of a one-year call option on Estelle stock with a strike price of $25.

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 Principles of Finance
HEC Lausanne Solution 7 December 2, 2019

Solution
In this case, the stock price either rises to Su = 25 ∗ 1.20 = 30 or falls to Sd = 25 ∗ 0.80 = 20.
The option payoff is therefore either Cu = 5 or Cd = 0. The replicating portfolio is ∆ =
(5 − 0)/(30 − 20) = 0.5 and B = (0 − 20 ∗ 0.5)/1.06 = −9.43.
Therefore, C = 0.5 ∗ 25 − 9.43 = $3.07.

Problem 3
Rebecca is interested in purchasing a European call on a hot new stock, Up, Inc. The call
has a strike price of $100 and expires in 90 days. The current price of Up stock is $120, and
the stock has a standard deviation of 40% per year. The risk-free interest rate is 6.18% per
year.
a. Using the Black-Scholes formula, compute the price of the call.
b. Use put-call parity to compute the price of the put with the same strike and expiration
date.
Simply applying the BS formula as presented in slides.
Via put-call parity and question (a), you should roughly obtain:
P = C + P V (K) − S = 23.29 + 98.487 − 120 = 1.78

Problem 4
Consider a future on a stock index that pays no dividends. The maturity of the futures
contract is one month. The current spot price of the index is S0 the current futures price is
F0 and the expected price of the stock index in one month is S1 . Compare the sizes of F0
and S1 .

Solution
F0 = S0 (1 + Rf ) < S0 (1 + µ) = S1 where µ is the expected return on the stock.