FINA 4512 Risk Management

SPRING 2015
Assignment
Full Name 1: _____Syl Yuejia Zhu_________________________________________
1. An investor believes that there will be a big jump in a stock price, but is uncertain as to
the direction. Identify the different strategies (about 4) the investor can follow and briefly
explain the differences among them. (Hint: There are potentially six different strategies)
1. Forward contract
Unlike options, the investor is obligated to buy the stock at the agreed price no
matter what the market price of the stock at maturity is while in an options
strategy, the investor can choose whether or not to exercise the option base on
current stock prices.
The fixing of the price in a forward contract eliminates uncertainty for the
investor but it has the most risk on its own as compared to options as the investor
is tied in and obligated to pay the agreed price when the contract expires.
Unlike futures contract, the details of a forward contract can be negotiated
privately and it is traded over the counter as opposed to publicly.
2. Creating a put/call option (straddle strategy)
The investor can profit from exercising the call option while losing just the price
paid for the put option if the stock price increases; or profit from exercising the
put option while losing just the price of the call if the stock price decreases.
Unlike other strategies, a straddle is only effective when the investor truly
believes that there will be a big jump in stock prices and this belief must be
different from most of that of other investors.
3. Stop-lost
In a stop-lost strategy, the investor can set a stop-loss order to buy or sell his
stock when it reaches his predetermined price. This helps him to limit his losses
but also locks in his profits.
Unlike a straddle strategy, a stop-lost strategy does not need to be monitored
daily, as the computer will automatically exercise the appropriate transactions
based on the price he set.
4. Speculating using stock futures contracts
If the investor expects a drop in prices, he can take on a short hedge. By selling
high now, he can repurchase the contract in the future at a lower price, hence

profiting from the lower costs. Alternatively, if the investor expects a rise in
prices, he can take on a long hedge and profit from the expected future price
increase.
Unlike forward contracts, futures contract are highly standardized and is traded
publicly.
Unlike put/call options, futures contract are binding and have to exercised at said
price no matter what the market price is.

2. Three call options on a stock have the same expiration date and strike prices of
$55, $60, and $65. The market prices are $9, $5, and $3, respectively. Explain how a
butterfly spread can be created. Construct a table showing the profit from the strategy.
For what range of stock prices would the butterfly spread lead to a loss? Plot a graph
of the final profits (after excluding cost) from the strategy (Y axis) for a closing stock
price range of $0 to $100 in increments of $5, on the X-axis.
To create a butterfly spread, the investor will:
Buy 1 in the money (in this case $55)
Sell 2 at the money (in this case $60)
Buy 1 out of the money (in this case $65)
Refer to excel table below.
Strike
price
$55.00
$60.00
$65.00

Call 1
Call 2
Call 3
Stock
Price
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19

Call
price ICF
$9.00
-$2.00
$5.00
$3.00

Payoffs
Profit
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00

-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00

20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62

$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$4.00
$3.00

-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$1.00
$0.00
$1.00
$2.00
$3.00
$2.00
$1.00

63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100

$2.00
$1.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00

$0.00
-$1.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00
-$2.00

According to the table, the butterfly spread leads to a loss when stock prices range from
$0 to $56 and $64 to $100. It breaks even when stock prices reaches $57 and $63 and
earns a profit when stock prices range from $58 to $62.

Refer to excel graph below.

Profits

Profits

3. Suppose that c1, c2, and c3 are the prices of European call options with strike prices
K1, K2, and K3, respectively, where K3 > K2 > K1 and K3 K2 = K2 K1. All options
have the same maturity. Assuming no arbitrage, what is the relation between c1, c2, and
c3?

Assuming that we input all variables into a butterfly spread scenario, it will go as follows:
Butterfly spread consists of
Buy 1 in-the-money
Sell 2 at-the-money
Buy 1 out-of-the-money

If stock price (St) < K1, then the payoffs from the portfolio should be:
020+0= 0

If K1 St K2, then the payoffs from the portfolio should be:

(St K1)20+0 = St K1

If K2 St K3, then the payoffs from the portfolio should be:

(St K1)2(St K2)+0 = 2K2 K1 St = K3 St

If K3 St, then the payoffs from the portfolio should be:

(St K1)2(St K2)+(St K3) = 2K2 (K1 +K3) = 0

As such:
The payoffs from the entire portfolio should always be more than or equals to 0
Hence, the relation between c1, c2, and c3 should be:

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

4. The price of a stock is $40. The price of a one-year European put option on the stock
with a strike price of $30 is quoted as $7 and the price of a one-year European call option
on the stock with a strike price of $50 is quoted as $5. Suppose that an investor buys 100
shares, shorts 100 call options, and buys 100 put options. Draw a diagram (to scale)
illustrating how the investors profit or loss varies with the stock price over the next year.
How does the answer change if the investor buys 100 shares, shorts 200 call options, and

buys 200 put options? Clearly show the payoffs using different graphs for each of the
securities (for example --- for calls, ___for stock, for puts, and ___ for the overall
payoff). Note: I expect is 2 diagrams, one for each scenario.
1st Scenario of buying 100 shares, short 100 calls, buy 100 puts:
Payoff = 100*(5-7)-100*Max(0,S-50)+100*Max(0,30-S)+100*(S-40)

Scenario 1

Buy Stock
Buy Put
Short Call
Payoff

2nd Scenario of buying 100 shares, short 200 calls, buy 200 puts:
Payoff = 200*(5-7)-200*Max(0,S-50)+200*Max(0,30-S)+100*(S-40)

Scenario 2

Buy Stock
Buy Put
Short Call
Payoff

5. You are given the following information from the WSJ and the Cumulative normal
distribution tables. The option matures in 1 year and is at the money. The current stock
price of the underlying stock is $90.00, and the annualized 365 day t-bill rate is 2.0%.
Assume that the annual variance of the stocks return is 1% per year. Compute the
following:

a)

The Black- Scholes- theoretical option price for a European Call option on the stock.
D1 = [ln (90/90) + (0.02 + 0.01/2)*1]/ [0.01*1]
= (0 + 0.025)/0.1
= 0.25
D2 = 0.25-[0.01*1]
= 0.25-0.1
= 0.15
N (D1) = 0.5987
N (D2) = 0.5596
CBS = 90*0.5987 (0.5596)*90e^(-0.02*1)
= $4.5153

b)

Using Put Call Parity, compute the price of a European Put option on a share of the
stock.
CBS = 90 90e^(-0.02*1) + P
P = 4.5153 1.7821
= $2.7332

c)

Use the stock price and strike price information from above. Assume that the stock
price can either go up by 10% or go down by 10% each period. Assume that each period
lasts 0.5 years. Set up a replicating portfolio of the stock and a risk free bond and use a
two-period binomial model. Assume that the risk free rate is 1.0% per period.

d)

Show CLEARLY the payoffs for the Stock, Bond and the Call for both periods.

binomial = bs / n = (0.01)/ (1) = 0.1

Stock price
Exercise
price
Rate

90
90
0.01

Sigma
Time
u
d
p
1-p

0.1
0.5
1.1
0.9
0.5251*
0.4749

P= [e^(0.01*0.5)-0.9]/(1.1-0.9)

Suu = 90*1.1^2
= 108.9
Sud = 90*1.1*0.9
= 89.1
Sdd = 90*0.9^2 = 72.9
Stock Value
$108.90
$99.00
$90.00

$89.10
$81.00
$72.90

Fuu = 108.9-90 = 18.9

Fud = 0
Fdd = 0
Fu = e^(-0.01*0.5)[0.5251*18.9+(1-p)*0] = 9.8749
Price of call

= e^(-2*0.01*0.5) * [18.9*0.5251^2 + 0*p(1-p) + 0*(1-p)^2]

= 0.9900 * 5.2113
= $5.1592

Call Value
$18.90
$9.87
$5.16

$0.00

$0.00
$0.00

e) Calculate the Number of Stocks and Bonds in both periods required to replicate the
call.
Equation 1 to calculate value of Su: 108.9+e^0.01B=18.9
Equation 2 to calculate value of Su: 89.1+e^0.01B=0
Solving equations, =0.9545, B=-84.1997
Value of Su: 99+B = 10.2958
Equation 1 to calculate value of Sd: 89.1+e^0.01B=0
Equation 2 to calculate value of Sd: 72.9+e^0.01B=0
Solving equations, =0, B=0
Value of Su: 81+B = 0
Equation 1 to calculate value of S0: 99+e^0.01B=10.2958
Equation 2 to calculate value of S0: 81+e^0.01B=0
Solving equations, =0.5720 (buy), B=-45.8710 (sell)

f) Using no Arbitrage, compute the price of the Call option using this replicating
portfolio.
Law of one price, since payoffs are equal, costs must be equal too.
Cost of synthetic portfolio = 0.5720*90 + -45.8710 = $5.609

g) Compute the probability (implied) that the stock price will go up.
Probability = [e^(0.01*0.5)-0.9]/(1.1-0.9) = 0.5251