Problems 1 through 10, part a).

Payoff #1 #2 Payoff #3
Payoff

+20
+20 +20
+10
+10 +10
0 S
+10 +20
0 S 0 S
+10 +20 +10 +20 -10
-10 -10

Payoff #4 Payoff #5 Payoff #6

+20 +20 +20

+10 +10 +10

0 S 0 S 0 S
+10 +20 +10 +20 +10 +20
-10 -10 -10

Payoff #7 Payoff #8 Payoff #9

+20 +20 +20

+10 +10 +10

0 S 0 S 0 S
+10 +20 +10 +20 +10 +20
-10 -10 -10

Payoff #10

+20

+10

0 S
+10 +20
-10

Fi8000 Practice Set #1 Check Solutions 1

 Problem b) Profitable Range c) Maximum Profit c) Maximum Loss
1 S < $22.80 $12.80 Unlimited
2 S > $22.60 $7.40 $2.60
3 S > $13.10 $6.90 $13.10
4 S < $7.00 and S > $33.00 Unlimited $8.00
5 S > $24.30 Unlimited $19.30
6 S > $30.20 Unlimited $10.20
7 S < $22.80 $12.80 Unlimited
8 S < $12.00 and S > $38.00 Unlimited $13.00
9 $12.20 < S < $27.80 $2.80 $2.20
10 S < $22.00 $2.00 $3.00

11. Long Put, X=20; Short Bond, FV=10.

12. Long Put, X=15; Long Call, X=25; Long Bond, FV=10.

13. Short Put, X=20; Short Call, X=25; Long Bond, FV=5.

14. Long Put, X=20; Short Put, X=10; Long Call, X=20; Short Call, X=30.

15. Short Put, X=20; Long Call, X=25; Short Call, X=30; Long Bond, FV=10.

16. Short Put, X=30; Lon Put, X=15; Short Call, X=30; Long Bond, FV=5.

17. Note that the payoff to Call A is always greater than or equal to the payoff to Call B. Since Call A is
cheaper, we buy Call A and write (sell) Call B, pocketing $1.25 today. At expiration, we use any payoff
from Call A to payoff anything due on Call B. At worst, we get zero at expiration and at best we get $10 at
expiration. Thus, we have an arbitrage opportunity. The table shows the transactions and cash flows.

Today (time 0)
Transaction Cash Flow
Buy a call, X=50 - 5.25
Write a call, X=60 + 6.50
Net cash flow + 1.25

Expiration (time 1)
Position S < 50 S = 50 50 < S < 60 S = 60 S > 60
Long call, X=50 0 0 S – 50 10 S – 50
Short call, X=60 0 0 0 0 60 – S
Net cash flow 0 0 0 to +10 +10 +10

18. This is similar to the last problem. The payoff to Put Z is always greater than or equal to the payoff to Put
Y. Since Put Z is cheaper, we buy Put Z and write (sell) Put Y, pocketing $0.75 today. At expiration, we
use any payoff from Put Z to payoff anything due on Put Y. At worst, we get zero at expiration and at best
we get $10 at expiration. Thus, we have an arbitrage opportunity. The table shows the transactions and cash
flows.

Today (time 0)
Transaction Cash Flow
Buy a put, X=40 - 2.50
Write a put, X=30 + 3.25
Net cash flow + 0.75

Fi8000 Practice Set #1 Check Solutions 2

 Expiration (time 1)
Position S < 30 S = 30 30 < S < 40 S = 40 S > 40
Long put, X=40 40 – S + 10 40 – S 0 0
Short put, X=30 S – 30 0 0 0 0
Net cash flow + 10 +10 0 to +10 0 0

19. We can now make general statements based on 17. and 18. Call options (on the same underlying stock and
the same expiration date) with lower strike prices must have premiums greater than or equal to the
premiums of call options with higher strike prices. So, C(X1) C(X2). Put options (on the same underlying
stock and the same expiration date) with lower strike prices must have premiums less than or equal to the
premiums of put options with higher strike prices. So, P(X1) P(X2).

20. According to put-call parity, P = C + X

− S . Using the interest rate and prices for the call and stock,
(1 + r )T
we can replicate a long position in a put at a cost of negative $2.68! The price of a put (whose minimum
payoff is zero) must be at least zero. So, we can get paid for “buying” portfolio that replicates a long
position in the put. This must be an arbitrage opportunity since we never have a negative cash flow and we
earn a profit. The table shows the transactions and cash flows.

Today (time 0)
Transaction Cash Flow
Buy a call, X=90 - 3.50
Buy a bond, FV=90 - 81.82
Short sell the stock + 88.00
Net cash flow + 2.68

Expiration (time 1)
Position S < 90 S = 90 S > 90
Long call, X=90 0 0 S – 90
Long bond, FV=90 + 90 + 90 + 90
Short stock -S - 90 -S
Net cash flow 0 to +90 0 0

X
21. According to put-call parity, P =C+ − S . Using the interest rate and prices for the call and
(1 + r )T
stock, we can replicate a long position in a put at a cost of $6.07. This is cheaper than we could buy the real
put. So, buy the portfolio that replicates the put and sell the real put. The table shows the transactions and
cash flows to answer part a).Note that the transactions in the table are the same no matter what you
replicate (call vs. put).
b) $6.07
c) $7.93
d) $76.07
e) 0.0000%

Today (time 0)
Transaction Cash Flow
Buy a call, X=80 - 6.00
Buy a bond, FV=80 - 78.07
Short sell the stock + 78.00
Write a put, X=80 + 8.00
Net cash flow + 1.93

Fi8000 Practice Set #1 Check Solutions 3

 Expiration (time 1)
Position S < 80 S = 80 S > 80
Long call, X=80 0 0 S – 80
Long bond, FV=80 + 80 + 80 + 80
Short stock -S - 80 -S
Short put, X=80 S – 80 0 0
Net cash flow 0 0 0

22. The deviation from put-call parity should be fairly small. If it is within $0.50 or so, then transaction costs
are very likely to wipe out any arbitrage profit. Also, the borrowing rate might be higher for us than the T-
bill rate. So, try the arbitrage strategy assuming that you must pay a premium in excess of 1% over the T-
bill rate. Again, this along with transaction costs should render any attempt at the arbitrage strategy costly
(i.e., no arbitrage). Also, be sure you have not chosen a dividend paying stock. What about early exercise?
These are American options. Put-call parity only applies to European options.
X
23. We can replicate the stock by rearranging the put-call parity formula as S =C+ − P . So, we
(1 + r ) T
replicate the stock by buying a call, buying a bond, and selling a put. Note that we have two strike prices,
so we can get two synthetic stock values:
X1 60
S1 = C( X 1) + − P( X 1) = 10 + − 3.50 = 63.10 and
(1 + r )T 1.06
X2 65
S2 = C ( X 2) + − P ( X 2) = 6 + − 4.50 = 62.82 . Since the replicating portfolio using
(1 + r )T 1.06
X2 is cheaper, we will buy this portfolio and sell the other portfolio that uses X1. Every time we do this, we
create a riskless position and pocket the difference between the costs of the two portfolios. We must now
show the cash flows at the relevant dates (time 0 is today and time 1 is at expiration) to show that this is an
arbitrage strategy. We enter into the positions today and check the value of those positions (assuming we
get out of the positions) at expiration. Because we are using two strike prices here, we must check the value
of our positions in 5 states of the world at expiration.

Today (time 0)
Transaction Cash Flow
Buy a call, X=65 -6.00
Buy bond, FV=65 -61.32
Write a put, X=65 +4.50
Write a call, X=60 +10.00
Sell a bond, FV=60 +56.60
Buy a put, X=60 -3.50
Net cash flow +0.28

Expiration (time 1)
Position S < 60 S = 60 60 < S < 65 S = 65 S > 65
Long call, X=65 0 0 0 0 S – 65
Long bond, FV=65 + 65 + 65 + 65 + 65 + 65
Short put, X=65 S – 65 -5 S – 65 0 0
Short call, X=60 0 0 60 – S -5 60 – S
Short bond, FV=60 - 60 - 60 - 60 - 60 - 60
Long put, X=60 60 – S 0 0 0 0
Net cash flow 0 0 0 0 0

Fi8000 Practice Set #1 Check Solutions 4

 24. As with the previous problem, we can rearrange the put-call parity formula to replicate the riskfree asset
X
(i.e., the bond). So, = P + S − C . Note that the right hand side of this equation is the portfolio
(1 + r )T
that replicates the bond that pays a return or r. So, to earn this rate we would buy the put and stock and
write a call. To determine what rate this portfolio will give us, we solve for the riskfree rate,
1

r = 
X  T − 1 . Solving for the rate using the options with a strike price of X1, we find that

 P + S −C 
r1=8.6957%. Using X2, we get r2=10%. Which rate should we “buy”? When we buy (i.e., invest), we want
the highest rate of return. Therefore, we should buy the portfolio using X2, since it gives us a riskfree
return of 10%. We want to sell the portfolio that uses X1, since we will essentially borrow that money at a
rate of 8.6957%.

The challenge here is to make sure that we never have a negative cash flow. If we were to naïvely buy the
portfolio using X1 and sell the portfolio using X2, then we would end up with negative cash flows. This
would violate the conditions for an arbitrage strategy. Since we are buying and selling bonds (really we are
buying and selling portfolios that replicate bonds), let’s make sure that we buy and sell bonds so that our
total “face value” (i.e., payment at maturity) is the same between what we buy and sell. Since the X1
“bond” (portfolio using X1) has a face value of $100 and the X2 “bond” has a face value of $110, we can
use 11 of the X1 “bond” and 10 of the X2 “bond” so that the total of both (i.e., the total face value) is
$1,100 at maturity or expiration. Again, we must show the transactions and cash flows to open the positions
today and the payoffs or values of these positions at expiration.
Note that I have left the “short 11 shares” and “long 10 shares” as separate transactions in order to make
this more transparent. Of course, we could just use “short 1 share,” leaving the result unchanged.

Today (time 0)
Transaction Cash Flow
Write 11 puts, X=100 + 132
Sell short 11 shares of + 1155
stock
Buy 11 calls, X=100 - 275
Write 10 calls, X=110 + 150
Buy 10 shares of stock - 1050
Buy 10 puts, X=110 - 100
Net cash flow +12

Expiration (time 1)
Position S < 100 S = 100 100 < S < 110 S = 110 S > 110
Short 11 puts, X=100 11S – 1100 0 0 0 0
Short 11 shares - 11S - 1100 - 11S - 1210 - 11S
Long 11 calls, X=100 0 0 11S – 1100 + 110 11S – 1100
Short 10 calls, X=110 0 0 0 0 1100 – 10S
Long 10 shares + 10S + 1000 + 10S + 1100 + 10S
Long 10 puts, X=110 1100 – 10S + 100 1100 – 10S 0 0
Net cash flow 0 0 0 0 0

Fi8000 Practice Set #1 Check Solutions 5

 25. a) $5.1542; N=0.8866, B=-41.84
b) $0.2311; N=-0.1134, B=6.24

26. a) $3.6165; N=0.6465, B=-29.35

b) $0.6934; N=-0.3535, B=18.72
c) The call premium increases and put premium decreases as the price of the underlying asset increases.

27. a) $1.5947; N=0.2743, B=-12.94

b) $1.4793; N=-0.7257, B=39.94
c) The call premium decreases and the put premium increases as the strike price increases.

28. a) $5.8302; N=0.7775, B=-35.38

b) $0.9071; N=-0.2225, B=12.70
c) The call and put premiums increase with an increase in volatility.

29. a) $5.9436; N=0.8866, B=-41.05

b) $0.1134; N=-0.1134, B=6.12
c) The call premium increases and the put premium decreases with an increase in the riskfree rate.

30. a) and c) $7.0564; Cu=$9.1631, Cd=$2.1357

b) and d) $0.2842; Pu=$0, Pd=$1.1386
e) The put and call premiums increase with an increase in time to expiration. Note: this is true, in general,
for all call options, but not for put options.

31. a) $3.4560; Cu=$4.8546, Cd=$0

b) $1.3067; Pu=$0.4993, Pd=$3.8105
c) $3.4560; Cu=$4.8546, Cd=$0
d) $1.8347; Pu=$0.4993, Pd=$5.9259
e) The is no value to early exercise for an American call, but there is value to the early exercise option for
some put options.

32. Since the market price for the real call is $4.75 and the price of the synthetic call (replicating portfolio) is
$5.1542, we should buy the real call and short sell the replicating portfolio. Below are the transactions and
cash flows that occur today (time 0) and at expiration (time 1). We show that we satisfy the three
conditions of an arbitrage opportunity.

Time 0 Time 1
Transaction CF Position CF (up) CF (down)
Short sell 0.8866 shares Short 0.8866 shares of
+$46.9904 -$50.7496 -$43.0596
of stock stock
Invest $41.8362 in the
-$41.8362 Long riskfree bond +$43.5096 +$43.5096
riskfree bond
Buy one real call -$4.7500 Long one call +$7.2400 $0.0000
Net cash flow +$0.4042 New cash flow $0.0000 $0.0000

33. Now the market price for the real call is higher than the price of the synthetic call. So, we should buy the
replicating portfolio and sell the real call.

Time 0 Time 1
Transaction CF Position CF (up) CF (down)
Buy 0.8866 shares of Long 0.8866 shares of
-$46.9904 +$50.7496 +$43.0596
stock stock
Borrow $41.8362 in the
+$41.8362 Short riskfree bond -$43.5096 -$43.5096
riskfree bond
Write a real call +$5.3750 Short one call -$7.2400 $0.0000
Net cash flow +$0.2208 New cash flow $0.0000 $0.0000

Fi8000 Practice Set #1 Check Solutions 6

 34. The market price for the real put is higher than the price of the synthetic put. So, we should buy the
replicating portfolio and sell the real put.

Time 0 Time 1
Transaction CF Position CF (up) CF (down)
Short sell 0.1134 shares Short 0.1134 shares of
+$6.0096 -$6.4904 -$5.5645
of stock stock
Invest $6.2408 in the
-$6.2408 Long riskfree bond +$6.4904 +$6.4904
riskfree bond
Write a real put -$0.5000 Short one put $0.0000 -$0.9259
Net cash flow +$0.2688 New cash flow $0.0000 $0.0000

35. The market price for the real call is higher than the price of the synthetic call. So, we should buy the
replicating portfolio and sell the real call. Because we have multiple time periods, we must rebalance our
portfolio at time 1 in order to replicate the payoffs of the call. Note that the rebalancing transactions cost us
nothing. In other words, the replicating portfolio is self-financing.

Time 0
Transaction CF
Buy 0.5945 shares of
-$31.5085
stock
Borrow $28.0525 against
+$28.0525
the riskfree bond
Write a real call +$4.0000
Net cash flow +$0.5440

Time 1 (stock goes up to $57.24)

Current position Desired position Rebalancing transaction CF
Long 0.5945 shares of Long 0.7732 shares of Buy 0.1787 shares of -$10.2400
stock stock stock
Owe $29.1745 Borrow $39.4046 Borrow $10.2400 more +$10.2400
Short one call Short one call - $0.0000
Net cash flow $0.0000

Time 1 (stock goes down to $49.07)

Current position Desired position Rebalancing transaction CF
Long 0.5945 shares of Long 0 shares of stock Sell 0. 5945 shares of +$29.1745
stock stock
Owe $29.1745 Owe nothing Repay loan -$29.1745
Short one call Short one call - $0.0000
Net cash flow $0.0000

Time 2 (stock price starts from $57.24 at time 1)

Position CF (S=$61.8192) CF (S=$53.0000)
Long 0.7732 shares of +$47.8000 +$40.9808
stock
Owe $40.9808 -$40.9808 -$40.9808
Short one call -$6.8192 $0.0000
Net cash flow $0.0000 $0.0000

Time 2 (stock price starts from $49.07 at time 1)

Position CF (S=$53.0000) CF (S=$45.4390)
Long 0 shares $0.0000 $0.0000
Owe nothing $0.0000 $0.0000
Short one call $0.0000 $0.0000
Net cash flow $0.0000 $0.0000

Fi8000 Practice Set #1 Check Solutions 7

Problems 36 through 40. You should use the Black-Scholes spreadsheet that I created.

Problem 41. Create your own spreadsheet and solve for the volatility. Recall that the option premiums increase as
the volatility increases.

Problem 42. It should be the case that the volatility implied (calculated) from the Black-Schole model (again, use a
spreadsheet that you’ve created) for the higher risk stocks should be higher.

Fi8000 Practice Set #1 Check Solutions 8