NUMERICAL PROBLEMS

1. The stock of ABC is selling for Rs 470. An American call price on this stock has exercise price of
Rs 450.

a. Calculate the intrinsic value of call.

b.How could you draw risk-less profit if option were priced at Rs 8 in the market?

Ans: a. Rs 20; b. Rs 12

SOLUTION
Here given:
Price of stock (ST) = Rs 470; Exercise price (E) = Rs 450
a. Intrinsic value of call (C) = ?
We have,
C = Max [(ST − E), 0] = Max [(Rs. 470 – Rs. 450), or 0] = Rs 20
b. If option were priced at Rs 8 (underpriced or market value is less than intrinsic value or minimum value), the arbitrageur
should buy option, exercise it by buying stock at Rs 350, and sell the stock at Rs 370 in the market.
Arbitrage profit = C – Call premium = Rs 20 – Rs 8 = Rs 12.

2. An American call on ZZZ stock is selling for Rs 25. The call has exercise price of Rs 440 and the
stock of ZZZ currently sells for Rs 455.

a. Calculate the intrinsic value of call option.

b. Calculate the time value of option.

Ans: a. Rs 15; b. Rs 10

SOLUTION
Here given:
Call premium (CP) = Rs 25; Exercise price (E) = Rs 440; Price of stock (ST) = Rs 455
a. Intrinsic value of call (C) = ?
We have,
C = Max [(ST − E), 0] = Max [(Rs. 455 – Rs. 440), or 0] = Rs 15
b.Time value = ?
We have, Time value = Market price – Intrinsic value = Rs 25 – Rs 15 = Rs 10
 76 FINANCIAL DERIVATIVES

3. Consider the following three call options:

Option Striking price Common stock price Option price
1 Rs. 120 Rs. 100 Rs. 4
2 100 100 Rs. 12
3 80 100 Rs. 30
a. Indicate which option is in-the-money, at-the-money and out-of-the-money.
b. Calculate the intrinsic value of each option.
c. Calculate the time value of the each option.
Ans: a. 3,2,1; b. Rs 0,Rs 0,Rs 20; c. Rs 4,Rs 12, Rs 10

SOLUTION
a.Moneyness of option
Option Moneyness Reason
1 Out-of-the-money Since the stock price is less than exercise price
2 At-the-money Since the stock price is equal with exercise price
3 In-the-money Since the stock price is higher than exercise price
b.Intrinsic value (C) = ?
We have,
C = Max [(ST − E), 0]
For option 1: C = Max [(Rs. 100 – Rs. 120), or 0] = Rs 0
For option 2: C = Max [(Rs. 100 – Rs. 100), or 0] = Rs 0
For option 1: C = Max [(Rs. 100 – Rs. 80), or 0] = Rs 20
c. Time value = ?
We have, Time value = Market price – intrinsic value
For option 1: Time value = Rs 4 – Rs 0= Rs 4
For option 2: Time value = Rs 12 – Rs 0 = Rs 12
For option 3: Time value = Rs 30 – 20 = Rs 10

4. Consider the following three put options:

Option Striking price Common stock Option price
price
1 Rs. 80 Rs. 100 Rs. 4
2 100 100 Rs. 12
3 120 100 Rs. 30
a. Indicate which option is in-the-money, at-the-money and out-of-the-money.
b. Calculate the intrinsic value of each option.
c. Calculate the time value of each option.
Ans: a. 3,2,1; b. Rs 0,Rs 0,Rs 20; c. Rs 4,Rs 12, Rs 10

SOLUTION
a.Moneyness of option
Option Moneyness Reason
1 Out of the-money Since the stock price is higher than exercise price
2 At-the-money Since the stock price is equal with exercise price
3 In-the-money Since the stock price is lower than exercise price
b.Intrinsic value (C) = ?
 PRINCIPLES OF OPTION Chapter 3 77

We have,
C = Max [(E - ST), 0]
For option 1: C = Max [(Rs. 80 – Rs. 100), or 0] = Rs 0
For option 2: C = Max [(Rs. 100 – Rs. 100), or 0] = Rs 0
For option 1: C = Max [(Rs. 120 – Rs. 100), or 0] = Rs 20
c. Time value = ?
We have, Time value = Market price – intrinsic value
For option 1: Time value = Rs 4 – Rs 0= Rs 4
For option 2: Time value = Rs 12 – Rs 0 = Rs 12
For option 3: Time value = Rs 30 – 20 = Rs 10

5. Consider a call option that expires today. The call has exercise price of Rs 210 and underlying
stock is selling for Rs 250.

a. Calculate the market price of call?

b. If call were priced at Rs 80 or Rs 30, how could you draw arbitrage profit?

Ans: a. Rs 40; b. Rs 40 and Rs 10

SOLUTION
a. Here given: Price of stock (ST) = Rs 250; Exercise price (E) = Rs 210
At expiration, market price equals to the intrinsic value,
We have,
C = Max [(ST − E), 0] = Max [(Rs. 250 – Rs. 210), or 0] = Rs 40
Therefore the price of call is Rs 40 per share.
b. If call were priced at Rs 80 (overpriced), the arbitrageur should sell option at Rs 80 and buy stock at Rs 250. When buyer
exercises call, he should sell stock to call buyer at Rs 210. Net profit = Rs 210 + 80 – 250 = Rs 40.
If call were priced at Rs 30 (underpriced), the arbitrageur should buy option at Rs 30; exercise it by buying stock at Rs 210.
Sell the stock at Rs 250 in the market. Net profit = Rs 250 – Rs 210 – Rs 30 = Rs 10.

6. A call option has Rs 530 exercise price and selling for Rs 73 and another similar call with Rs 550
exercise price is selling for Rs 85. Do you see any arbitrage opportunity there? Explain.

Ans: Sell call with Rs 550 exercise price and buy call with Rs 530 exercise price

SOLUTION
Exercise price of first call option (E1) = Rs 530, Exercise price of second call option (E2) = Rs 550
Call premium for first call option (C1) = Rs 73 Call premium for second call option (C2) = Rs 85
Rule regarding exercise price: C (S0, T, E1) ≥ C(S0, T, E2) 73 < 85
The rule is violated and there is arbitrage opportunity.
The arbitrageur should sell call with Rs 550 exercise price for Rs 85 and buy call with Rs 530 exercise price for Rs 73. Initial
net inflow = Rs 85 – Rs 73 = Rs 12. At expiration, if both call became out-of-the-money, they will not be exercised and no
cash flow will occur at that time. If calls became in-the-money, arbitrageur exercises long call by buying stock at Rs 530.
Short call will also be exercised and arbitrageur sells stock at Rs 550 under short call. Net inflow at expiration = Rs 550 –
Rs 530 = Rs 20. Total profit = Rs 20 + Rs 10 = Rs 30.
 78 FINANCIAL DERIVATIVES

7. The stock price of Morning Star Company is Rs 140. A call option on this stock has exercise
price of Rs 125 and selling for Rs 20. Another call option on this stock has Rs 130 exercise price
and selling for Rs 12. Both calls are American and expire after 6 months.

a. Examine whether they confirm the rules regarding American calls that differ only by exercise
price. Also suggest arbitrage strategy if any.

b. Assume the options are European. Examine whether they confirm the rules regarding
European options that differ only by exercise price. Also show the arbitrage strategy if any. The
risk-free rate is 5% p.a.

Ans: a. Yes. Sell call with Rs 125 exercise price and buy call with Rs 130 exercise price; b. Rule does
not confirm. Sell call with Rs 125 exercise price and buy call with Rs 130 exercise price.
SOLUTION
a. Rule 1: Call with higher exercise price has lower premium.
C(S0, T, E1) ≥ C(S0, T, E2).
20 > 12
The rule is confirmed and there is no arbitrage opportunity.
Rule 2: E2 – E1 ≥ C(S0, T, E1) - C(S0, T, E2)
130 – 125≥ 20 – 12
5 < 8.
The rule does not confirm. There is arbitrage opportunity.
The arbitrageur should sell call with Rs 125 exercise price for Rs 20 and buy call with Rs 130 exercise price for Rs 12.
There will be initial cash inflow of Rs 20 – Rs 12 = Rs 8. If calls became in-the-money and short call is exercised, the
arbitrageur will receive Rs 125 by selling stock. But he will also exercise long call by paying Rs 130 for the stock. This will
result Rs 130 – Rs 125 = Rs 5 cash outflow. Since he has already received Rs 8, net profit to him will be Rs 8 – Rs 5 = Rs
3.

b. Risk-free rate is 5% per annum

Rule 1: the rule for American and European option is same. Thus, rule is confirmed as in problem 5.
Rule 2: (E2 – E1)(1+r)-t ≥ C (S0, T, E1) - C (S0, T, E2)
(130 – 125)(1+0.05)-0.5 ≥ 20 – 12
4.88 < 8. The rule is not confirmed and there is an arbitrage opportunity.
The arbitrageur should sell call with Rs 125 exercise price for Rs 20 and buy call with Rs 130 exercise price for Rs 12.
There will be initial cash inflow of Rs 20 – Rs 12 = Rs 8. At expiration, if calls became in-the-money and short call is
exercised; the arbitrageur will receive Rs 125 by selling stock. But he will also exercise long call by paying Rs 130 for the
stock. This will result Rs 130 – Rs 125 = Rs 5 cash outflow. Since he has already received Rs 8, net profit to him will be Rs
8 – Rs 5 = Rs 3.

8. Suppose that the current stock price is Rs 200, the exercise price is Rs 200, the annually
compounded interest rate is 5 percent, the stock pays Rs 2 dividend in the next instant, and the
quoted European call price is Rs 6 for a one year option. Identify the appropriate arbitrage
opportunity and show the appropriate arbitrage strategy.

Ans: Lower bound = Rs 7.52; Market price < lower bound, sell stock and buy call
Solution
The most likely arbitrage opportunity is a violation of a lower boundary condition. With dividends, the lower boundary for a
call is expressed as:
 PRINCIPLES OF OPTION Chapter 3 79

Ce(S0,T,E)≥Max [S0 – D – E(1+r)t, 0] = Max [200 – 1 – 200 (1+ 0.05)-1] =Rs 7.52
Note that the present value of the dividend is D, because the dividend is paid in an instant. Because the lower boundary is
higher than the quoted call price of Rs 6, there is an arbitrage opportunity. One method to assess the appropriate trading
strategy is to rearrange the boundary condition such that one side is greater than zero. In this case, the boundary is non-
zero and it is violated, therefore
S0 – D – E(1+r)t - Ce(S0,T,E) > 0
Or 200 – 2 – 200 (1+0.05)-1 – 6 = Rs 1.52 > 0
To generate Rs 1.52 in cash flow today, execute the trades suggested by their symbols, short sell stock, lend the present
value of the strike price, and buy the call option. In the next instant, the short seller must pay the dividend. One way to
demonstrate that this is an arbitrage is to create a cash flow table.
Strategy Today At Expiration: ST < At Expiration: ST ≥
E E
Short sell of +S0–D –ST –ST
stock
Borrow –E(1+r)-t +E +E
Buy call –Ce 0 ST – E
Net +S0–D–E(1+r)-t –C e E – ST (positive due 0
= 1.52 to ST<E)
Therefore, Rs 1.52 per share is generated today without any chance of a future liability. This is a money machine and
clearly an arbitrage opportunity. Notice that selling pressure on the stock will drive its price down and buying pressure on
the call will drive its price up. Hence, this trading activity will eventually eliminate the arbitrage opportunity.

9. Janata stock is currently selling for Rs. 200. Stock pays Rs. 6 dividend after 6 months and one
year from now. A European call option on Janata has exercise price of Rs. 188 and one year to
expiration. The risk-free rate of interest is currently 12% per annum. Do you see any arbitrage
opportunities if this call is selling for Rs. 15?

Ans: Lower bound = Rs 21.11

SOLUTION
Current price of stock (S0) = Rs. 200
Exercise price (E) = Rs. 188
Risk-free rate (r) = 12% p.a.
Dividend of Rs. 6 after each 6 months
To know the arbitrage opportunities. Let's check for lower bound of European call.
Lower bound = Max (S0* = E (1 + r)–t, 0]
S0* = S0 – PV of dividend
6 6
= 200 – +
(1.12)6/12 (1.12)
= Rs. 188.97
Lower bound = Max [188.97 – 188 (1.12)–1, 0]
= Max [188.97 – 167.863]
= Rs. 21.11
Since, market price is lower than lower bound, there is arbitrage opportunity. The arbitrageur should buy call and sell stock.
Cash flows and profit are summarized in following table.
 80 FINANCIAL DERIVATIVES

Cash flow Expiration cash flows

today If ST < E (ST = 250) If ST > E (ST = 150)
Short stock + 200 –250 –150
Long call –15 + 62 +0
+ 185 –188 –150
Value of dividend paid with –[6 (1.12)6/12 + 6] = – –[6 (1.12)6/12 + 6] = –
interest 12.35 12.35
Value of initial inflow at 185 (1.12)1 = 207.2 185 (1.12)1 = 207.2
expiration with interest
Arbitrage profit 6.85 44.65

10. Suppose a put option on Zebra stock is expiring today. The exercise price of put is Rs 300 and
Zebra stock is selling for Rs 220.

a.Calcualte the intrinsic value of put option.

b. How will an arbitrage react if the market price of put is (i) Rs 95 (ii) Rs 65.

Ans: a. Rs80; b. sell put, sell stock; (ii) buy stock and buy put
SOLUTION
a.Value of put at expiration (P)
Intrinsic value (P) = Max [(E – ST), 0] = Max [(300 – 220), 0] = Rs 80
b. Sell put at Rs 95, sell short a stock at Rs 220. Buy stock at Rs 300 when buyer exercises the put. Cover the short
position of stock. Net profit = Rs 95 + Rs 220 – Rs 300 = Rs 15.
Buy put at Rs 65, buy stock at Rs 220, exercise put by selling stock at Rs 300. Net profit = Rs 300 – Rs 220 – Rs 65 = Rs
15.
11. The current price of Mechi stock is Rs 360 currently. A put option on this stock with 1 month to
expiration has exercise price of Rs 400 and selling for Rs 90. Another put option on same stock
with same time to expiration has exercise price of Rs 380 and selling for Rs 60.

a. Both options are American. Examine whether they confirm the rules regarding American puts
that differ only by exercise price. Also suggest the arbitrage strategy if any.

b. Assume the options are European. The risk free rate of interest is 10% per annum. Examine
the rules regarding exercise price and suggest arbitrage opportunities if any.

Ans: a. Does not confirm. Buy put with Rs 380 exercise price and sell put with Rs 400 exercise price.;
b. Does not confirm. Sell put with Rs 380 exercise price and buy put with Rs 400 exercise price.;
SOLUTION
a. Here given:
Exercise price of put 2 (E2) = Rs 400; Exercise price of put 1 (E1) = Rs 380
Put premium of put 2 (PP2) = Rs 60 Put premium of put 1 ( P1) = Rs 90
Rule 1: Pa (S0, T, E2) ≥ Pa (S0, T, E1)
Rs 60 < Rs 90
Rule is not confirmed.
Arbitrage strategy
 PRINCIPLES OF OPTION Chapter 3 81

Sell put with Rs 380 exercise price and buy put with Rs 400 exercise price. Net inflow = Rs 90 – Rs 60 = Rs 30. If both puts
became out-of-the-money, they would not be exercised and Rs 30 would be net benefit for the position. If both puts became
in-the-money and exercised, buy stock at Rs 380 under short put and sell stock at Rs 400 under long put. Again, cash
inflow of Rs 20 would be received. Net from position would be Rs 30 + Rs 20 = Rs 50.

b. Rule 1: Pe (S0, T, E2) ≥ Pe (S0, T, E1)

Rs 60 < Rs 90
Rule doesn’t not confirm
Arbitrage strategy
Sell put with Rs 380 exercise price and buy put with Rs 400 exercise price. Net inflow = Rs 90 – Rs 60 = Rs 30. If both puts
became out-of-the-money, they would not be exercised and Rs 30 would be net benefit for the position. If both puts became
in-the-money and exercised, buy stock at Rs 380 under short put and sell stock at Rs 400 under long put. Again, cash
inflow of Rs 20 would be received. Net from position would be Rs 30 + Rs 20 = Rs 50.

12. Suppose that the current stock price is Rs 900, the exercise price is Rs 1000, the annually
compounded interest rate is 5 percent, the stock pays Re 10 dividend in the next instant, and the
quoted put price is Rs 60 for a one year option. Identify the appropriate arbitrage opportunity
and show the appropriate arbitrage strategy.

Ans: Lower bound = Rs 62.4; Market price < lower bound, borrow PV of E, buy stock and buy put.

SOLUTION
The most likely arbitrage opportunity is a violation of a lower boundary condition. With dividends, the lower boundary for a
put is expressed as:
Pe (S0, T, E) ≥ Max [0, E (1+r)-t – S0 +D] = Max [0, 1000 (1+ 0.05)-1 – 900 +10] = Rs 62.4
Again we see that the present value of the dividend is D, because it occurs in an instant. Because the lower boundary is
higher than the quoted call price of Rs 6, there is an arbitrage opportunity. One method to assess the appropriate trading
strategy is to rearrange the boundary condition such that one side is greater than zero. In this case, the boundary is non-
zero and it is violated, therefore
E (1+r)t – S0 + D – Pe(S0,T,E) > 0
Or 1000 (1+ 0.05)-1 – 900 +10 – 60 = 2.4
To generate Rs 2.4 in cash flow today, execute the trades suggested by their symbols, borrow the present value of the
exercise price, buy stock, and buy the put option. In the next instant, the stock buyer will receive the dividend. One way to
demonstrate that this is an arbitrage is to create a cash flow table.
Strategy Today At Expiration: ST < At Expiration: ST ≥ E
E
Borrow +E(1+r)-t –E –E
Buy stock –S0+D +ST +ST
Buy put –Pe E–ST 0
Net +S0–D–E(1+r)-t– 0 ST–E
Ce (non-negative due to
= 2.4 ST ≥ E)
Therefore, Rs 2.4 per share is generated today without any chance of a future liability. This is a money machine and clearly
an arbitrage opportunity. Notice that buying pressure on the stock will drive its price up and buying pressure on the put will
drive its price up. Hence, this trading activity will eventually eliminate the arbitrage opportunity.

13. Lower bound of put. The NBL stock sells for Rs. 500 today. A European put on NBL expires after 6
months and has an exercise price of Rs. 525 now discrete dividend on stock is Rs. 20 after one
82 FINANCIAL DERIVATIVES

month and Rs. 10 after another one month. Annual risk-free rate is 10% p.a. Calculate the lower
bound and identify arbitrage opportunity, if any, if put is selling at Rs. 15.

Ans: Lower bound = Rs 20.33

SOLUTION
S0 = Rs. 500 E = Rs. 525 σ = 10%
t = 6 months div = Rs. 10 after one month and two months from now.
Dividend adjusted stock price (S0*) = S0 – PV of div.
10 10
= 500 – – = Rs. 480.24
(1.1)1/12 (1.1)2/12
Lower bound = Max [525 (1.1)–6/12 – 480.24, 0]
= Max [ 500.57 – 480.24, 0]
= Rs. 20.33
Since market price is less than lower bound, there is an arbitrage opportunity. The arbitrageur should buy put and buy
stock. The cash flows are shown as:
Cash flow Expiration cash flows
today If ST > E (ST = 560) If ST < E (ST = 450)
Long put –15 35 75
Short put –500 +560 +450
–515 +595 525
Value of dividend [6(1.1)5/12+ 6 (1.1)4/12] = [6(1.1)5/12+ 6 (1.1)4/12] =
20.73 20.73
Value of initial cash flow at –515(1.1)6/12 = –540.14 –515(1.1)6/12 = –540.14
expiration
Arbitrage profit 75.59 5.59

14. The following option prices were observed for a stock on July 6 of a particular year. Unless
otherwise indicated, ignore dividends on the stock. The stock is priced at 165.13. The
expirations are July 17, August 21, and October 16. The risk-free rates are 0.0516, 0.0550,
and 0.0588, respectively.
c Call a Put
Strike July August October July August October
155 10.50 11.80 14.00 0.20 1.25 2.75
160 6.00 8.10 11.10 0.75 2.75 4.50
165 2.70 5.20 8.10 2.35 4.70 6.70
170 0.80 3.20 6.00 5.80 7.50 9.00
(i) Compute the intrinsic values, time values, and lower bounds of the following calls.
Identify any profit opportunities that may exist. Treat these as American options for
purposes of determining the intrinsic values and time values and European options
for the purpose of determining the lower bounds.
a. July 160
b. October 155
c. August 170
(ii) Compute the intrinsic values, time values, and lower bounds of the following puts.
Identify any profit opportunities that may exist. Treat these as American options for
purposes of determining the intrinsic values and time values and as European options
for the purpose of determining the lower bounds.
a. July 165
 PRINCIPLES OF OPTION Chapter 3 83

b. August 160
c. October 170
(iii) Examine the following pairs of calls, which differ only by exercise price. Determine
whether any violate the rules regarding relationships between American options that
differ only by exercise price.
a. August 155 and 160
b. October 160 and 165
(iv) Examine the following pairs of puts, which differ only by exercise price. Determine if
any violate the rules regarding relationships between American options that differ
only by exercise price.
a. August 155 and 160
b. October 160 and 170
(v) Check the following combinations of puts and calls, and determine whether they
conform to the put-call parity rule for European options. If you see any violations,
suggest a strategy.
a. July 155
b. August 160
c. October 170
(vi) Repeat part (v) using American put-call parity, but do not suggest a strategy. In each
case we compute the value of C + E, P + S0 , and C + E(1 + r) -T . The values should line up in
descending order.

Ans: (i) (a) Intrinsic value = Rs 5.13; Time value = Rs 0.87; Lower bound = Rs 5.37; (b) Intrinsic
value = Rs 10.13; Time value = Rs 3.87; Lower bound = Rs 12.579; (c) Intrinsic value = Rs 0; Time
value = Rs 3.20; Lower bound = Rs 0;
(ii) a. Intrinsic value = 0 Time value = 2.35; Lower bound = 0; b. Intrinsic value = 0 Time value =
2.75 Lower bound = 0; c. Intrinsic value = 4.87; Time value = 4.13; Lower bound = 2.184;
(iii) (a) Rs 5 > Rs 3.7; (b) Rs 5 > Rs 3, No arbitrage opportunities
(iv) (a) Rs 5 > Rs 1.5; (b) Rs 10 > Rs 4.5; No arbitrage opportunities;
(v) (a) 165.33 ≈ 165.2675 ; (b) 167.88 ≈ 167.028; (c) 174.13 ≈ 173.314
(vi) (a) 165.5 & 165.33; (b) 168.10 & 167.875; (c) 176 & 174.13

Solution
(i) a.July 160
Intrinsic value = Max [(165.13 – 160),0] = Rs 5.13
Time value = 6 – 5.13 = Rs 0.87
Lower bound:
T = 11/365 = 0.0301
(1 + r)-t = (1.0516)-0.0301 = 0.9985
Lower bound = Max [0, 165.13 – 160(0.9985)] = Rs 5.37
b. October 155
Intrinsic value = Max [0, 165.13 – 155] = Rs 10.13
Time value = 14 – 10.13 = Rs 3.87
Lower bound:
T = 102/365 = .2795
(1 + r)-t = (1.0588)-0.2795 – 1 = 0.9842
Lower bound = Max [0, 165.13 – 155(0.9842)] = Rs 12.579
c. August 170
84 FINANCIAL DERIVATIVES

Intrinsic value = Max [0, 165.13 – 170] = Rs 0

Time value = 3.20 – 0 = Rs 3.20
Lower bound:
T = 46/365 = 0.1260
(1 + r)-t = (1.0550)-0.1260 = 0.9933
Lower bound = Max [0, 165.13 – 170(0.9933)] = Rs 0
All prices conform to the boundary conditions, so there are no profitable opportunities.

(ii) a July 165

Intrinsic value = Max(0, 165 - 165.13) = 0 Time value = 2.35 - 0 = 2.35
Lower bound = Max(0, 165(0.9985) - 165.13) = 0
b. August 160
Intrinsic value = Max(0, 160 - 165.13) = 0
Time value = 2.75 - 0 = 2.75
Lower bound = Max(0, 160(0.9933) - 165.13) = 0

c. October 170
Intrinsic value = Max(0, 170 - 165.13) = 4.87
Time value = 9 - 4.87 = 4.13.
Lower bound = Max(0, 170 (0.9842) - 165.13) = 2.184
All prices conform to the boundary conditions, so there are no profitable opportunities.

(iii)The difference in premiums of American calls should not exceed the difference in exercise
prices
Pair Difference in premium Different in exercise prices
August 155 and 160 3.7 5
October 160 and 165 3 5
Neither pair represents a violation

(iv) The difference in premiums of American calls should not exceed the difference in exercise
prices.
Pair Difference in premium Different in exercise prices
August 155 and 160 1.5 5
October 160 and 170 4.5 10
Neither pair represents a violation

(v) In each case, we compute the value of P + S0 and compare it to the value C + E (1 + r) -T .
a. July 155 P + S0 = 0.20 + 165.13 = 165.33
C + E (1 + r) -T = 10.5 + 155(.9985) = 165.2675 Difference = 0.0625

b. August 160
P + S0 = 2.75 + 165.13 = 167.88
C + E (1 + r) -T = 8.10 + 160(.9933) = 167.028
Difference = 0.852

c. October 170 P + S0 = 9 + 165.13 = 174.13

C + E (1 + r) -T = 6 + 170(.9842) = 173.314
Difference = 0.816.
 PRINCIPLES OF OPTION Chapter 3 85

These values are supposed to be zero. If arbitrage could be executed at a cost less than the indicated
difference, it would be advisable to do so. Consider the October 170 combination. The difference of
0.816 suggests that a portfolio of short put, long call, short stock, and long risk-free bonds would
generate a cash inflow of 0.816 with no cash outflow at expiration, assuming, of course, that there is
no early exercise.

(vi) a. July 155

C + E = 10.5 + 155 = 165.5
P + S0 = 0.20 + 165.13 = 165.33
C + E (1 + r) -T = 10.5 + 155(0.9985) = 165.2675
These align correctly.

b. August 160
C + E = 8.10 + 160 = 168.10
P + S 0 = 2.75 + 165.13 = 167.875
C + E (1 + r) -T = 8.10 + 160(.9933) = 167.028
These align correctly.

c. October 170
C + E = 6 + 170 = 176
P + S0 = 9 + 165.13 = 174.13
C + E (1 + r) -T = 6 + 170(0.9842) = 173.314
These align correctly

15. On December 9 of a particular year, a January Swiss franc call option with an exercise price
of 46 had a price of 1.63. The January 46 put was at 0.14. The spot rate was 47.28. All prices
are in cents per Swiss franc. The option expired on January 13. The U.S. risk-free rate was
7.1 percent, while the Swiss risk-free rate was 3.6 percent. Do the following:
a. Determine the intrinsic value of the call.
b. Determine the lower bound of the call.
c. Determine the time value of the call.
d. Determine the intrinsic value of the put.
e. Determine the lower bound of the put.
f. Determine the time value of the put.
g. Determine whether put-call parity holds.
Ans: a. 1.28; b. 1.42; c. 0.35; d. 0; e. 0; f. 0.14; g. 1.5615

Solution
The time period is from December 9 to January 13 is 35 days. So T = 35/365 = 0.0959
a. Intrinsic Value = Max(0, S0 - E) = Max(0, 47.28 - 46) = 1.28
b. Lower bound = Max[0, S0 (1 + ρ )-T – E (1 + r) -T ]
= Max[0, 47.28(1.036) -0.0959 - 46(1.071) -0.0959 ] = 1.42
c. Time Value = call price - intrinsic value = 1.63 - 1.28 = 0.35
d. Intrinsic Value = Max(0, E – S0 ) = Max(0, 46 - 47.28) = 0
e. Lower bound = Max[0, E (1 + r) -T – S0 (1 + ρ ) T ]
= Max[0, 46(1.071) -.0959 - 47.28(1.036) -.0959 ]
= 0 (Note: this is the lower bound only for a European put.)
f. Time value = put price – intrinsic value = 0.14 – 0 = 0.14
g. C = P + S0 (1 + ρ -T ) – E(1 + r) -T
86 FINANCIAL DERIVATIVES

The left-hand side is 1.63. The right hand side is 0.14 + 47.28(1.036) -0.0959 – 46(1.071) -0.0959
= 1.5615
Put-call parity does not hold; however, transaction costs could account for the difference

♦-♦