Assume that you have just been hired as a financial analyst by Triple Play, a mid-sized California

company that specializes in creating high-fashion clothing. Because no one at Triple Play is familiar
with the basics of financial options, you have been asked to prepare a brief report that the firm’s
executives can use to gain a cursory understanding of the topic.

To begin, you gathered some outside materials on the subject and used these materials to draft a
list of pertinent questions that need to be answered. In fact, one possible approach to the report is
to use a question-and-answer format. Now that the questions have been drafted, you have to
develop the answers.

a. What is a financial option? What is the single most important characteristic of an option?

A financial option is a contract which gives its holder the right to buy (or sell) an asset at a
predetermined price within a specified period of time. An option’s most important
characteristic is that it does not obligate its owner to take any action; it merely gives the
owner the right to buy or sell an asset.

b. Options have a unique set of terminology. Define the following terms:

1. Call option
A call option is an option to buy a specified number of shares of a security within some
future period.

2. Put option
A put option is an option to sell a specified number of shares of a security within some
future period.

3. Strike price or exercise price

The strike price is the price stated in the option contract at which the security can be
bought (or sold).

4. Expiration date
The expiration date is the last date the option can be exercised.

5. Exercise value
The exercise value is the value of a call option if it were exercised today, and it is equal
to the current stock price minus the strike price. Note: the exercise value is zero if the
stock price is less than the strike price.

6. Option price
The option price is the market price of the option contract.

7. Time value
The time value is the difference between the option price and the exercise value.
 8. Writing an option
Writing a put or call option refers to an investment contract in which a fee is paid for
the right to buy or sell shares at a future date.

9. Covered option
A covered option is a call option written against stock held in an investor's portfolio.

10. Naked option

A naked option is an option sold without the stock to back it up.

11. In-the-money call

An in-the-money call is a call option whose strike price is less than the current price of
the underlying stock.

12. Out-of-the-money call

An out-of-the-money call is a call option whose strike price exceeds the current stock
price.

13. LEAPS
LEAPS stand for long-term equity anticipation securities. They are similar to
conventional options except they are long-term options with maturities of up to 2.5
years.

c. Consider Triple Play’s call option with a $25 strike price. The following table contains
historical values for this option at different stock prices:

Stock Price Call Option Price

$25 $3.00

30 7.50

35 12.00

40 16.50

45 21.00

50 25.50
 1. Create a table that shows (a) stock price, (b) strike price, (c) exercise value, (d) option
price, and (e) the time value, which is the option’s price less its exercise value.

Stock price Strike price Exercise value Call option price Time value
(A) (B) (C) = (A-B) (D) (E) = (D-C)
$25.00 $25.00 $0 $3.00 $3.00
$30.00 $25.00 $5.00 $7.50 $2.50
$35.00 $25.00 $10.00 $12.00 $2.00
$40.00 $25.00 $15.00 $16.50 $1.50
$45.00 $25.00 $20.00 $21.00 $1.00
$50.00 $25.00 $25.00 $25.50 $0.50

2. What happens to the time value as the stock price rises? Why?

As the table shows, the option’s time value declines as the stock price increases. This
is due to the declining degree of leverage provided by options as the underlying stock
prices increase, and to the greater loss potential of options at higher option prices.

d. Consider a stock with a current price of P = $27. Suppose that over the next 6 months the
stock price will either go up by a factor of 1.41 or down by a factor of 0.71. Consider a call
option on the stock with a strike price of $25 that expires in 6 months. The risk-free rate is
6%.

1. Using the binomial model, what are the ending values of the stock price? What are the
payoffs of the call option?

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒, 𝑃 = $27.00 ; 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒, 𝑟𝑅𝐹 = 6% ;

𝑆𝑡𝑟𝑖𝑘𝑒 𝑝𝑟𝑖𝑐𝑒, 𝑋 = $25.00 ; 𝑈𝑝 𝑓𝑎𝑐𝑡𝑜𝑟 𝑑𝑒 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒, 𝑢 = 1.41
𝐷𝑜𝑤𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 𝑑𝑒 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒, 𝑑 = 0.71 ; 𝑦𝑒𝑎𝑟𝑠 𝑡𝑜 𝑒𝑥𝑝𝑖𝑟𝑎𝑡𝑖𝑜𝑛, 𝑡 = 0.50

Binomial payoffs
𝑆𝑡𝑟𝑖𝑘𝑒 𝑝𝑟𝑖𝑐𝑒: 𝑋 = $25.00
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒: 𝑃 = $27.00
𝑈𝑝 𝑓𝑎𝑐𝑡𝑜𝑟 𝑑𝑒 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒: 𝑢 = 1.41
𝐷𝑜𝑤𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 𝑑𝑒 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒: 𝑑 = 0.71
𝑈𝑝 𝑓𝑎𝑐𝑡𝑜𝑟 𝑝𝑎𝑦𝑜𝑓𝑓: 𝐶𝑢 = 𝑀𝐴𝑋[0, 𝑃(𝑢) − 𝑋] = $13.07
𝐷𝑜𝑤𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 𝑝𝑎𝑦𝑜𝑓𝑓: 𝐶𝑑 = 𝑀𝐴𝑋[0, 𝑃(𝑑) − 𝑋] = $0.00

Current stock price P = $27

Ending “up” stock price = P(u) = $38.07

Option payoff: Cu = MAX [0, P(u) – X] = $13.07

Ending “down” stock price = P(d) = $19.17

Option payoff: Cd = MAX [0, P(d) – X] = –$5.53 = $0.00
2. Suppose you write one call option and buy Ns shares of stock. How many shares must
you buy to create a portfolio with a riskless payoff (i.e., a hedge portfolio)? What is the
payoff of the portfolio?

We can form a portfolio by writing 1 call option and purchasing Ns shares of stock. We
want to choose Ns such that the payoff of the portfolio if the stock price goes up is the
same as if the stock price goes down. This is a hedge portfolio because it has a riskless
payoff.
𝐶𝑢 − 𝐶𝑑 $13.07 − $0
𝑁𝑠 = = = 0.6915
𝑃(𝑢 − 𝑑) $27(1.41 − 0.71)

The hedge portfolio with riskless payoffs

𝑆𝑡𝑟𝑖𝑘𝑒 𝑝𝑟𝑖𝑐𝑒: 𝑋 = $25.00
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒: 𝑃 = $27.00
𝑈𝑝 𝑓𝑎𝑐𝑡𝑜𝑟 𝑑𝑒 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒: 𝑢 = 1.41
𝐷𝑜𝑤𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 𝑑𝑒 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒: 𝑑 = 0.71
𝑈𝑝 𝑓𝑎𝑐𝑡𝑜𝑟 𝑝𝑎𝑦𝑜𝑓𝑓: 𝐶𝑢 = 𝑀𝐴𝑋[0, 𝑃(𝑢) − 𝑋] = $13.07
𝐷𝑜𝑤𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 𝑝𝑎𝑦𝑜𝑓𝑓: 𝐶𝑑 = 𝑀𝐴𝑋[0, 𝑃(𝑑) − 𝑋] = $0.00
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑖𝑛 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜: 𝑁𝑠 = (𝐶𝑢 − 𝐶𝑑 )/𝑃(𝑢 − 𝑑) = 0.691

Current stock price P = $27

stock price = P(u) = $38.07

Portfolio stock payoff: P(u)(Ns) = $26.33
Subtract option’s payoff: Cu = $13.07
Portfolio’s net payoff: P(u)(Ns) – Cu = $13.26

stock price = P(d) = $19.17

Portfolio stock payoff: P(d)(Ns) = $13.26
Subtract option’s payoff: Cd = $0.00
Portfolio’s net payoff: P(d)(Ns) – Cd = $13.26

3. What is the present value of the hedge portfolio? What is the value of the call option?
The present value of the riskless payoff discounted at the risk-free rate (we assume
daily compounding) is:

N = (0.5) (365) = 182.5

I / yr = 6% / 365 = 0.0164%
PMT = 0
FV = $13.26
1 1
𝑃𝑉 = 𝐹𝑉 𝑛
= $13.26 = $12.87
(1 + 𝑟) (1 + 0.000164)182.5

𝑝𝑎𝑦𝑜𝑓𝑓 $13.26
𝑃𝑉 𝑜𝑓 𝑝𝑎𝑦𝑜𝑓𝑓 = 365∗𝑡
= = $12.87
(1 + 𝑟𝑅𝐹 ⁄365) 1.030
 The current value of the hedge portfolio is the stock value (Ns x P) less the call value
(VC). But the hedge portfolio has a riskless payoff, so the hedge portfolio's value must
also be equal to the present value of the riskless payoff discounted at the risk-free rate
(we assume daily compounding):

Vc = Ns (P) – PV of riskless payoff

Vc = (0.6915*27) – 12.87
Vc = $5.80

4. What is a replicating portfolio? What is arbitrage?

If you borrow an amount equal to the present value of the riskless payoff and buy Ns
shares of stock, the payoffs of this portfolio replicate the payoffs of the call option.

Ns = 0.6915
Amount borrowed = PV of riskless payoff = $12.87
Repayment of riskless payoff = $13.26

Payoff if stock is up:

Stock price = $38.07
Value of stock in portfolio = Ns*stock price = 0.6915 * $38.07 = $26.33
Less repayment of borrowing = $13.26
Net payoff of portfolio = $26.33 - $13.26 = $13.07

Payoff if stock is up:

Stock price = $19.17
Value of stock in portfolio = Ns*stock price = 0.6915 * $19.17 = $13.26
Less repayment of borrowing = $13.26
Net payoff of portfolio = $13.26 - $13.26 = $0.00

Notice that these are the same payoffs of the option.

e. In 1973, Fischer Black and Myron Scholes developed the Black-Scholes option pricing
model (OPM).

1. What assumptions underlie the OPM?

The assumptions which underlie the OPM are as follows:

• The stock underlying the call option provides no dividends during the life of the
option.

• No transactions costs are involved with the sale or purchase of either the stock or
the option.
 • The short-term, risk-free interest rate is known and is constant during the life of
the option.

• Security buyers may borrow any fraction of the purchase price at the short-term,
risk-free rate.

• Short-term selling is permitted without penalty, and sellers receive immediately

the full cash proceeds at today's price for securities sold short.
• The call option can be exercised only on its expiration date.

• Security trading takes place in continuous time, and stock prices move randomly in
continuous time.

2. Write out the three equations that constitute the model.

𝑉𝑐 = 𝑃[𝑁(𝑑1 )] − 𝑋𝑒 −𝑟𝑅𝐹 𝑡 [𝑁(𝑑2 )]

2
𝑙𝑛(𝑃⁄𝑋) + [𝑟𝑅𝐹 + (𝜎 ⁄2)] 𝑡
𝑑1 =
𝜎√𝑡

𝑑2 = 𝑑1 − 𝜎√𝑡

𝑉𝑐 = current value of a call option with time t until expiration.

𝑃 = current price of the underlying stock.
𝑁(𝑑𝑖 ) = probability that a deviation less than di will occurs in a standard normal
distribution. Thus, 𝑁(𝑑1 ) and 𝑁(𝑑2 ) represent areas under a standard normal
distribution function.
𝑋 = strike price of the option.
𝑒 ≈ 2.7183.
𝑟𝑅𝐹 = risk-free interest rate.
t = time until the option expires (the option period).
𝑙𝑛(𝑃⁄𝑋) = natural logarithm of P/X.
𝜎 2 = variance of the rate of return on the stock.

3. According to the OPM, what is the value of a call option with the following
characteristics?

Stock price = $27.00

Strike Price = $25.00
Time to expiration = 6 month = 0.5 years
Risk-free rate = 6.0%
Stock return standard deviation = 0.49
The input variables are:

𝑃 = $27.00 ; 𝑋 = $25.00 ; 𝑟𝑅𝐹 = 6.0% ; 𝑡 = 0.5 𝑦𝑒𝑎𝑟𝑠 ; 𝜎 2 = 0.49

Now, we proceed to use the OPM:

2
𝑙𝑛(𝑃⁄𝑋) + [𝑟𝑅𝐹 + (𝜎 ⁄2)] 𝑡
𝑑1 =
𝜎√𝑡

𝑙𝑛 ($27⁄$25) + [0.06 + (0.49⁄2)]0.5

𝑑1 =
(0.7)(0.7071)
0.077 + 0.1525
𝑑1 =
0.495
𝑑1 = 0.4636

𝑑2 = 𝑑1 − 𝜎√𝑡

𝑑2 = 0.4636 − (√0.49)(√0.5)

𝑑2 = −0.03139

𝑁(𝑑1 ) = 𝑁(0.4636) = 0.6785

𝑁(𝑑2 ) = 𝑁(−0.0314) = 0.4875

Therefore,

𝑉𝑐 = 𝑃[𝑁(𝑑1 )] − 𝑋𝑒 −𝑟𝑅𝐹 𝑡 [𝑁(𝑑2 )]

𝑉𝑐 = $27[0.6785] − $25𝑒 −(0.06)(0.5) [0.4875]

𝑉𝑐 = $18.32 − $25(0.97)(0.4875)

𝑉𝑐 = $18.32 − $11.83

𝑉𝑐 = $6.49

Thus, under the OPM, the value of the call option is about $6.50.
f. What impact does each of the following parameters have on the value of a call option?

1. Current stock price

The value of a call option increases (decreases) as the current stock price increases
(decreases).

2. Strike price
As the strike price of the option increases (decreases), the value of the option
decreases (increases).

3. Option’s term to maturity

As the expiration date of the option is lengthened, the value of the option increases.
This is because the value of the option depends on the chance of a stock price
increase, and the longer the option period, the higher the stock price can climb.

4. Risk-free rate
As the risk-free rate increases, the value of the option tends to increase as well. Since
increases in the risk-free rate tend to decrease the present value of the option's strike
price, they also tend to increase the current value of the option.

5. Variability of the stock price

The greater the variance in the underlying stock price, the greater the possibility that
the stock's price will exceed the strike price of the option; thus, the more valuable the
option will be.

g. What is put–call parity?

Put-call parity specifies the relationship between puts, calls, and the underlying stock price
that must hold to prevent arbitrage:

Put + Stock = Call + PV of Strike Price