EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

EF4420 Derivative Analysis and Advanced Investment Strategies

Problem Set 6

This problem set is to be turned in by Wednesday, March 31st 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: In the put call parity, the left-hand side is

c + KerT + D = 2 + 30e0.16/12 + 0.5e0.12/12 + 0.5e0.15/12 = 31.508.

The right-hand side is

p + S0 = 2.3 + 29 = 31.3.

Thus, an arbitrage exists. An arbitrage strategy is as follows:

Action Cash flow today Cash flow in 2 months Cash flow in 5 months Cash flow in 6 months
ST 30 ST < 30
short call 2 0 0 (ST 30) 0
long put -2.3 0 0 0 (30 ST )
buy stock -29 0.5 0.5 ST ST
0.12/12
sell 2-month bond 0.5e -0.5 0 0 0
0.15/12
sell 5-month bond 0.5e 0 -0.5 0 0
0.16/12
sell 6-month bond 30e 0 0 -30 -30
Net 0.208 0 0 0 0

1 Instructor: Yongjin Kim

EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

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

Solution: The investor needs to long put with K1 and short put with K2 . The payoff is as follows:

Stock price range Long put with K1 Short put with K2 Net payoff
ST < K1 K1 ST (K2 ST ) K1 K2
K1 ST < K2 0 (K2 ST ) ST K2
ST K2 0 0 0

3. 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: This strategy requires $14 as the initial investment. The payoff and profit is as follows:

Stock price range Long call Long two puts Net payoff Net profit
ST < 60 0 2(60 ST ) 2(60 ST ) 2(60 ST ) 14
ST 60 ST 60 0 ST 60 ST 60 14

To make a positive profit, the stock price should be

2(60 ST ) 14 > 0 or ST 60 14 > 0.

Thus, ST < 53 or ST > 74.

2 Instructor: Yongjin Kim

EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

4. Combining Bull and Bear Spreads

We see the following European options in the market:

Option Strike Price ($) Option Price ($)

call 30 8.5
call 40 4.0
put 30 3.2
put 40 8.0

All of the options will expire in year one. Suppose that we combine the bull spread (long a $30-strike call
and short a $40-strike call) and the bear spread (long a $40-strike put and short a $30-strike put).

(a) Construct the table showing the final payoff of this strategy.

Solution: The payoff is

Stock price range Long call with 30 Short call with 40 Short put with 30 Long put with 40 Net payoff
ST < 30 0 0 (30 ST ) 40 ST 10
30 ST < 40 ST 30 0 0 40 ST 10
ST 40 ST 30 (ST 40) 0 0 10

(b) How much initial investment does this strategy require? What is the risk-free interest rate?

Solution: The required initial investment is 8.5 - 4.0 - 3.2 + 8.0 = 9.3. If we invest in this strategy, we
will get risk-free cash flow of $10 one year later. Then, the implied risk free rate r satisfies

er1 = 10/9.3

r = 7.26%.

3 Instructor: Yongjin Kim