EF4520 Principles of Option Pricing - Semester A 2016

EF4520 Principles of Option Pricing Problem Set 2

This problem set is to be turned in by September 30th, Friday 11:00 pm. Please present your work using
MS Word or PDF and submit online on Canvas. You may use Excel for calculation but the final solution
should be presented in MS Word or PDF.

1. Arbitrage Using Options on Dividend-Paying Stock

The price of a European call that expires in 6 months and has a strike price of $30 is $2. A European put
with the same expiration date and the same strike price is priced at $2.3. The underlying stock price is $29,
and a dividend of $0.50 is expected in 2 months and again in 5 months. The risk-free interest rate is 10%.
Is there an arbitrage opportunity? If so, show an arbitrage strategy and its profit.

Solution: Check whether the put-call parity holds.

rT 0.10.5
c + Ke = 2 + 30e = $30.54
0.11/6 0.15/12
p + S0 D = 2.3 + 29 0.5e 0.5e = $30.33

0.11/6 0.15/12
where, D = 0.5e + 0.5e = 0.971. We find the put option is underpriced, so there is an
arbitrage. Thus, we consider the following arbitrage strategy

Action today Today T

ST 30 ST < 30
buy put option -2.3 0 (30 ST )
0.10.5
buy share -29 ST + 0.971 e ST + 0.971 e0.10.5
sell call option 2 (ST 30) 0
0.10.5
sell bond 30 e + 0.971 -(30+0.971e0.10.5 ) -(30+0.971e0.10.5 )
net 0.208 0 0

We make an arbitrage profit of $0.208.

1 Instructor: Yongjin Kim

EF4520 Principles of Option Pricing - Semester A 2016

2. Butterfly Spread
Suppose that c1 , c2 , and c3 are the prices of European call options with the strike prices K1 , K2 , and K3 ,
respectively, where K3 > K2 > K1 and K3 K2 = K2 K1 . All options have the same maturity. Show that

c2 0.5(c1 + c3 )

Hint 1: Consider a butterfly spread, that is long one option with strike price K1 , long one option with strike
price K3 , and short two options with strike price K2 .
Hint 2: Show that the payo of the butterfly spread at the option maturity is always positive or zero. Then,
we can deduce the relation among current option prices.

Solution: Consider the butterfly spread as suggested. Then, the payo is

If ST > K3
(ST K1 ) + (ST K3 ) 2(ST K2 ) = K1 K3 + 2K2 = 0

If K2 < ST K3
(ST K1 ) + 0 2(ST K2 ) = ST K1 + 2K2 = K3 ST 0

If K1 < ST K2
(ST K1 ) + 0 0 = ST K1 > 0

If ST < K1
0+0 0=0

Thus, the payo the portfolio is always non-negative. Thus, the current value of the portfolio is also greater
than or equal to 0:

c1 + c3 2c2 0
)0.5(c1 + c3 ) c2

3. Bull Spreads
Suppose that an investor wants to create a bull spread using two put options with the same expiration date
but dierent strike prices K1 and K2 (> K1 ). What positions should the investor take for these two options?
Also, construct a table showing the payo the the spread.

2 Instructor: Yongjin Kim

EF4520 Principles of Option Pricing - Semester A 2016

Solution: To construct a bull spread, the investor needs to buy the put option with K1 and sell the put
option with K2 . Then, the payo is

Stock price Payo from Payo from Total

range long put option short put option payo
ST K2 0 0 0
K1 < ST < K2 0 (K2 ST ) ST K2
ST K 1 K1 ST (K2 ST ) K1 K2

4. Strip
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 a strip (long a call and long two puts). For what range of stock
prices would the strip lead to a positive profit?

Solution: The initial cost to set up the strip is 6 + 2 4 = $14.

Stock price Payo from Payo from Total Profit

range long call option long put option payo
ST 60 (ST 60) 0 (ST 60) (ST 60) 14
ST < 60 0 2(60 ST ) 2(60 ST ) 2(60 ST ) 14

We have a positive profit when either (ST 60) 14 > 0 or 2(60 ST ) 14 > 0. Solving for ST , the range
is ST > 74 or ST < 53.

3 Instructor: Yongjin Kim