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

EF4420 Derivative Analysis and Advanced Investment Strategies

Problem Set 5

This problem set is to be turned in by Wednesday, March 24th 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 Put

Consider a 1-year European put option on a stock. The option has the strike price of $40 and the option
price is $7. The stock will pay no dividend until the option maturity and is currently priced for $30. The
risk-free interest rate is 2%. Is there an arbitrage? If so, find the arbitrage strategy and its profit.

Solution: First, we can check the lower and upper bound of the option price. The lower bound is
0.021 0.021
max(40e 30, 0) = 9.208, while the upper bound is 40e = 39.208. We find that the op-
tion price is lower than the lower bound, so an arbitrage exists. One arbitrage strategy is

Action Cash flow today Cash flow in year 1

ST 40 ST < 40
long put -7 0 40-ST
buy stock -30 ST ST
0.02
sell bond 40e -40 -40
Net 2.208 ST 40 0

2. Arbitrage Using Put and Call

The price of a non-dividend-paying stock is $19 and the price of a 3-month European call option on the
stock with a strike price of $20 is $1. The risk-free rate is 4% per annum. The price of a 3-month European
put option with a strike price of $20 is $1.7. Is there an arbitrage? If so, find the arbitrage strategy and its
profit.

Solution: First, lets see whether the put-call parity holds:

c + KerT = 1 + 20e0.043/12 = 20.801

1 Instructor: Yongjin Kim

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

while
p + S = 1.7 + 19 = 20.7.

We find the call option is relatively over-priced compared to the put. Thus, we consider the following
arbitrage strategy

Action today Today T

ST 20 ST < 20
long put option -1.7 0 (20 ST )
buy share -19 ST ST
short call option 1 (ST 20) 0
0.043/12
sell bond 20e 20 20
net 0.101 0 0

The arbitrage profit is $0.101.

3. Convexity of Option Prices

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 portfolio where we 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 payoff of the portfolio at the option maturity is always positive or zero. Then, we
can deduce the relation among current option prices.

Solution: The portfolios payoff at the maturity is as follows:

Stock price Payoff from Payoff from Payoff from Total

range long call long call short calls payoff
with K1 with K3 with K2
ST < K1 0 0 0 0
K1 ST < K2 ST K1 0 0 ST K1
K2 ST < K3 ST K1 0 2(ST K2 ) ST + 2K2 K1 (= ST + K3 )
ST K3 ST K1 ST K3 2(ST K2 ) K1 K3 + 2K2 (= 0)

2 Instructor: Yongjin Kim

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

We find that in all of the stock price ranges, the total payoff is zero or positive. Thus, the present value of
the portfolio should be zero or positive, that is

c1 + c3 2c2 0

Hence,
0.5(c1 + c3 ) c2

3 Instructor: Yongjin Kim