Solution to Midsem FRAM

Q1: To construct the strategy (collar), the investor must purchase the stock, sell a call option with a
high strike price, and buy a put option with a low strike price. So, to find the cost of the strategy, we
need to find the price of the call option and the price of the put option. We can use Black–Scholes to
find the price of the call option, which will be:

Price of call option with $75 strike price:

d1 = [ln($60/$75) + (.07 + .502/2)  (6/12)] / (.50  (6 /12) ) = –.3554

d2 = –.3554 – (.50  6 /12 ) = –.7089

N(d1) = .3612

N(d2) = .2392

Putting these values into the Black–Scholes model, we find the call price is:

C = $60(.3612) – ($75–.07(6/12))(.2392)
C = $4.35

Now we can use Black–Scholes and put–call parity to find the price of the put option with a strike
price of $45. Doing so, we find:

Price of put option with $45 strike price:

d1 = [ln($60/$45) + (.07 + .502/2)  (6/12)] / (.50  (6 /12) ) = 1.0895

d2 = 1.0895 – (.50  6 /12 ) = .7359

N(d1) = .8620

N(d2) = .7691

Putting these values into the Black–Scholes model, we find the call price is:

C = $60(.8620) – ($45e–.07(6/12))(.7691)
C = $18.30

Rearranging the put–call parity equation, we get:

P = C – S + Ee–Rt
P = $18.30 – 60 + 45e–.07(6/12)
P = $1.75
 The investor will buy the stock, sell the call option, and buy the put option, so the total cost is:

Total cost of the strategy = $60 – 4.35 + 1.75 = $57.41

Q2:
A financial institution has just sold 1,000 seven-month European call options on the Japanese
yen. Suppose that the spot exchange rate is 0.80 cent per yen, the exercise price is 0.81 cent per
yen, the risk-free interest rate in the United States is 8% per annum, the risk-free interest rate in
Japan is 5% per annum, and the volatility of the yen is 15% per annum. Calculate the delta,
gamma, vega, theta, and rho of the financial institution’s position. Interpret each number.

In this case S0 = 080 , K = 081 , r = 008 , rf = 005 ,  = 015 , T = 05833

ln(080  081) + ( 008 − 005 + 0152  2 )  05833
d1 = = 01016
015 05833
d 2 = d1 − 015 05833 = −00130

N(d1)=0.5405; N(d2)=0.4948
− rf T
The delta of one call option is e N (d1 ) = e −00505833  05405 = 05250 .
1 − d12  2 1 −000516
N (d1 ) = e = e = 03969
2 2
so that the gamma of one call option is
−r T
N (d1 )e f 03969  09713
= = 4206
S0 T 080  015  05833
The vega of one call option is
−r T
S0 T N (d1 )e f = 080 05833  03969  09713 = 02355
The theta of one call option is
−r T
S0 N (d1 ) e f −r T
− + rf S0 N (d1 )e f − rKe − rT N (d 2 )
2 T
08  03969  015  09713
=−
2 05833
+005  08  05405  09713 − 008  081 09544  04948
= −00399
The rho of one call option is
KTe− rT N (d 2 )
= 081 05833  09544  04948
= 02231

Delta can be interpreted as meaning that, when the spot price increases by a small amount
(measured in cents), the value of an option to buy one yen increases by 0.525 times that amount.
Gamma can be interpreted as meaning that, when the spot price increases by a small amount
(measured in cents), the delta increases by 4.206 times that amount. Vega can be interpreted as
meaning that, when the volatility (measured in decimal form) increases by a small amount, the
option’s value increases by 0.2355 times that amount. When volatility increases by 1% (= 0.01)
the option price increases by 0.002355. Theta can be interpreted as meaning that, when a small
amount of time (measured in years) passes, the option’s value decreases by 0.0399 times that
amount. In particular when one calendar day passes it decreases by 00399  365 = 0000109 .
Finally, rho can be interpreted as meaning that, when the interest rate (measured in decimal
form) increases by a small amount the option’s value increases by 0.2231 times that amount.
When the interest rate increases by 1% (= 0.01), the options value increases by 0.002231.

Q3:
Suppose that the result of a major lawsuit affecting a company is due to be announced tomorrow.
The company’s stock price is currently $60. If the ruling is favorable to the company, the stock
price is expected to jump to $75. If it is unfavorable, the stock is expected to jump to $50. What is
the risk-neutral probability of a favorable ruling? Assume that the volatility of the company’s
stock will be 25% for six months after the ruling if the ruling is favorable and 40% if it is
unfavorable. Calculate the relationship between implied volatility and strike price for six-month
European options on the company today. The company does not pay dividends. Assume that the
six-month risk-free rate is 6%. Consider call options with strike prices of $30, $40, $50, $60,
$70, and $80.

Suppose that p is the probability of a favorable ruling. The expected price of the company’s
stock tomorrow is
75 p + 50(1 − p) = 50 + 25 p
This must be the price of the stock today. (We ignore the expected return to an investor over one
day.) Hence
50 + 25 p = 60
or p = 04 .
If the ruling is favorable, the volatility,  , will be 25%. Other option parameters are
S0 = 75 , r = 006 , and T = 05 . For a value of K equal to 50, the value of a European call
option price as 26.502.
If the ruling is unfavorable, the volatility,  will be 40% Other option parameters are S0 = 50 ,
r = 006 , and T = 05 . For a value of K equal to 50, the value of a European call option price as
6.310.
The value today of a European call option with a strike price today is the weighted average of
26.502 and 6.310 or:
04  26502 + 06  6310 = 14387

the implied volatility when the option has this price. The parameter values are S0 = 60 , K = 50 ,
T = 05 , r = 006 and c = 14387 . The implied volatility is 47.76%.
These calculations can be repeated for other strike prices. The results are shown in the table
below. The pattern of implied volatilities is shown in Figure S20.1.
Strike Price Call Price: Call Price: Weighted Implied Volatility
Favorable Outcome Unfavorable Outcome Price (%)
30 45.887 21.001 30.955 46.67
40 36.182 12.437 21.935 47.78
50 26.502 6.310 14.387 47.76
60 17.171 2.826 8.564 46.05
70 9.334 1.161 4.430 43.22
80 4.159 0.451 1.934 40.36

50
Implied Vol (%)

48
46
44
42
40
38
20 40 60 80
Strike Price