Seminar 9 – Problem 1 December 1, 2014

Group # 21:

Andreas Rendler
andreas.rendler@uni-konstanz.de

Problem 1

Problem setting

A speculator expects a decrease in price of XYZ stock. He buys 5 put option contracts (one
option contract is on 100 pieces of XYZ stock) with strike price 110 EUR. The option
premium is equal to 2 EUR.
Now (at time 0), XYZ stock is traded for 125 EUR.

1.What is the initial investment of the speculator?

Later (at time t), XYZ stock is traded for 115 EUR and the put option for 5 EUR.

2.What is the %-profit the speculator can gain by closing the options position (i.e.when
selling the options)?

3. Calculate the %-earning in case the speculator profits on the price decrease by short-
selling 500 pieces of XYZ stock instead. Compare the earning with the profit from options. 2

Solution

Given:
 Out of the money put option (strike price< stock price).
 Number of option contracts: 𝑛=5
 Number of shares per contract: 𝑚 = 100
 Option premium at time 0: 𝑃0 = 2€
 Stock price at time 0: 𝑆0 = 125€
 Option premium at time t: 𝑃𝑡 = 5€
 Stock price at time 0: 𝑆𝑡 = 115€

Question n.1:

 Calculate the initial investment (𝐼0 ):

𝑰𝟎 = 𝑛 . 𝑃0 = 5 . 2€ = 𝟏𝟎€

Answer: The initial investment of the speculator is 10€.

Question n.2:

 Calculate the value (𝐼𝑡 ) generated by selling the options at time t:

𝑰𝒕 = 𝑛 . 𝑃𝑡 = 5 . 5€ = 𝟐𝟓€

 Calculate the revenue (𝑟𝑒𝑣𝑜𝑝𝑡𝑖𝑜𝑛 ) generated by selling the option at time t:

𝒓𝒆𝒗𝒐𝒑𝒕𝒊𝒐𝒏 = 𝐼𝑡 − 𝐼0 = 25€ − 10€ = 𝟏𝟓€

 Calculate the %-profit (𝑝𝑜𝑝𝑡𝑖𝑜𝑛 ) generated by selling the option at time t:

𝑟𝑒𝑣𝑜𝑝𝑡𝑖𝑜𝑛 15€
𝒑𝒐𝒑𝒕𝒊𝒐𝒏 = = = 1.5 = 𝟏𝟓𝟎%
𝐼0 10€

Answer: The speculator can gain a profit of 150% by closing the option position.

Question n.3:

 Calculate the value (𝑉0 ) of an investment in 500 pieces of the stock at time 0:

𝑽0 = 500 . 𝑆0 = 500 . 125€ = 𝟔𝟐𝟓𝟎𝟎€

 Calculate the value (𝑉𝑡 ) of an investment in 500 pieces of the stock at time t:

𝑽𝒕 = 500 . 𝑆𝑡 = 500 . 115€ = 𝟓𝟕𝟓𝟎𝟎€

 Calculate the revenue (𝑟𝑒𝑣𝑠ℎ𝑜𝑟𝑡 ) generated by short-selling the stock:

𝒓𝒆𝒗𝒔𝒉𝒐𝒓𝒕 = 𝑉0 − 𝑉𝑡 = 62500€ − 57500€ = 𝟓𝟎𝟎𝟎€

 Calculate the %-earnings (𝑝𝑠ℎ𝑜𝑟𝑡 ) generated by short-selling the stock:

𝑟𝑒𝑣𝑠ℎ𝑜𝑟𝑡 5000€
𝒑𝒔𝒉𝒐𝒓𝒕 = = 62500€ = 0.08 = 𝟖%
𝑉0

Answer: The speculator can gain a profit of 8% by short-selling the stock. He can gain much
more value by investing in the out of the money option (150%). This difference is caused by a
non-proportionally increase in the option premium.
Financial Market instruments I

Problem 2- exercise 9
group number 17
group members: Tomáš Václavíček, Lucie Scheerová, Michal Kolář
email address: michal.kolar81@gmail.com

Assignment:

On 1st October, stock OINK that pays a dividend of 8 % p.a. twice a year (September and
March) is currently traded at 95 EUR. The risk-free interest rate is 10% and March put with
strike 105 EUR has a premium of 15 EUR.

1. Is the option in-the-money or out-of-the-money?

Put option is in-the-money when strike price > spot price
Put option is out-of-the-money when strike price < spot price
105 EUR (strike price) > 95 EUR (spot price)
Our option is in-the-money.

2. What is the intrinsic and extrinsic (time) value?

Intrisic value for 1. October = strike price - spot price = 105-95 = 10 EUR
option premium = intrisic value + time value
15 = 10 + time value
time value = 5 EUR

3. What is the maximum loss of the portfolio (long stock + long put)?

This particular combination of option and underlying asset is known as the

“protective put”. By combining the long put with a long position in the stock, we
essentially created a synthetic call option. The situation can be described by the
graph below, which shows the profit of the portfolio (dark blue) together with the
profit on stock (green) and payoff from the put option (light blue).
 Payoff from long stock, long put and total
profit
150

100

50

78

174
0
6
12
18
24
30
36
42
48
54
60
66
72

84
90
96
102
108
114
120
126
132
138
144
150
156
162
168

180
186
192
198
-50

-100

-150

Profit on the stock Profit on the option Portfolio profit

We take the current stock price (St = 95) as the initial price (as initial price is not
mentioned in the problem setup)¨

Assumptions:
- Between 1st October and 1st March are 153 days, year has 365 days (we use the
Actual/Actual convention)
- Risk free interest rate = 0,1 (converted to unit form)
- Option premium = 15 EUR
- Current stock price = 95 EUR (we take it as the clearing price for dividend in March)
- dividend rate = 0,08 (converted to unit form)

Maximum loss = option premium paid for holding option + opportunity cost when we
save option premium in bank (=> interest) - profit from holding the stock – dividend

In the payoff graph for both the stock and the put option above, we can see that if
the price of stock declines to zero, the profit from the stock would be -95 EUR, but
the decline of the stock price is covered by the put option. Together, these two terms
give us the loss of 5 EUR for every stock price below 105 EUR. This loss needs to be
adjusted for dividends received and for the lost interest (opportunity cost).
 The effect of dividends which the investor collects from the stock is such that this
additional profit decreases the maximum loss by 0.04 x 95 = 3.8 EUR.

We have two types of maximum losses:

1) Accounting cost - adjusted only for profit from holding the stock (dividend)
=> Accounting cost = 5 - 0,04 x 95 = 1.2 EUR
2) Economic cost – adjusted for profit from holding the stock (dividend) and
opportunity cost when we save option premium in bank (=> interest)
=> Economic cost = 5 - 0,04 x 95 + 15 x 0,1 x (153/365) = 1.83 EUR (after
rounding)

If we consider that our long stock goes to the maximum considerable loss which is
limit to zero => The company goes bankrupt and pays out no dividends. In this
scenario, we would get these maximum losses:

1) Accounting cost - adjusted only for profit from holding the stock (dividend)
=> Accounting cost = 5 + 0,04 x (limlong stock -> 0) = 5 EUR (after rounding)
2) Economic cost – adjusted for profit from holding the stock (dividend) and
opportunity cost when we save option premium in bank (=> interest)
=> Economic cost = 5 + 0,04 x (limlong stock -> 0) + 15 x 0,1 x (153/365) = 5,6 EUR
(after rounding)

4. What is the maximum profit of the portfolio?

Since we created a synthetic call option, the profit is technically unlimited and is
maximized when stock price is maximized. However, for any price of stock higher
than 105, we have to substract the option premium from the profit which we receive
from the stock.

On the other hand, we collect dividends on the stock, which brings us additional
profit of 3.8 EUR (as shown above).

The maximum profit is then (St max – S0) – Premium + Dividend = Unlimited
maximum profit
Seminar 9 – Problem 3 27 November 2014

Group #23

Andrea Havrilová, Khrystyna Pastukh, Lenka Šperková

kristina.pastukh@gmail.com

Problem 3
Problem setting

Call options on a stock are available with strike prices of $15, $17 ½ and $20 and expiration
dates in 3 months. Their prices are $4, $2 and $1/2, respectively.

Question n.1
Explain how the options can be used to create a butterfly spread.

Question n.2
Construct a table showing how profit varies with stock price for the butterfly spread.

Solution

Question n.1

Butterfly spreads are combinations of two spreads.

Butterfly call spread is the combination of a long call with a low exercise price, two short calls
with a middle exercise price and a long with a high exercise price.

In our case we will buy call options of $15 and $20 and also sell two call options of $17.5.
Furthermore we can calculate initial investment:
$4 + $0.5 – 2 × $2 = $0.5

Question n.2

We have 3 strike prices: $15, $17.5 and $20 and four possible profits and losses. The higher
profit is in middle stock price at $17.5 and it shows a loss if it is distant from the middle price.

STOCK PRICE St ≤ 15 15 ˂ St ≤ 17.5 17.5 ˂ St ≤ 20 St ˃ 20

PROFIT/LOSS -0.5 (St – 15) – 0.5 (20 - St) – 0.5 -0.5
Seminar 9 – Problem 4 Decembre 1, 2014

Group #10

Jan Matyáš, Aneta Mohylová, Eva Smotlachová

eva.smotlachova@gmail.com

Problem 4
Problem setting

Suppose that put options on a stock with a strike prices $30 and $35 cost
$4 and $7, respectively.

1. How can the options be used to create a

–Bull spread
–Bear spread

2. Construct a table that shows the profit and payoff for both spreads.

Solution

1.
In our case, we can create a vertical bull put spread or a vertical bear put spread.

vertical (cylinder) spreads are combinations of options with the same expiry date but
different exercise prices

vertical bull put spread is the combination with a long put option with a low
exercise price and a short put option with a high exercise price
- This strategy generates profits if the underlying remains constant or if
you appreciate
- Therefore, this strategy is used if investors expect the price of the underlying
to appreciate and especially to reduce risk
- The short put generates income, whereas the long put's main purpose is to
offset risk and protect the investor in case of a decline in price
- In our case: we buy a put option with a strike price of $30 at cost $4 and sell
the put option with the strike price $35 at cost $7.
- Investor will receive a premium when initiating this position

vertical bear put spread is the combination of a short put option with a low exercise
price and a long put option with a high exercise price
Seminar 9 – Problem 4 Decembre 1, 2014

- It consists of buying one put in hopes of profiting from a decline in the

underlying stock, and buying another put with the same expiration, but with a
lower strike price, as a way to offset some of the cost
- In our case: we sell the put option with the strike price of $30 at cost $4 and
buy the put option with the strike price $35 at cost $7.
- This strategy requires a net cash outlay when initiating the position

2.
We have two points where the profit/loss function changes – these are our strike
prices $30 and $35.

For the vertical bull put spread:

Stock price St ≤ 30 30 < St ≤ 35 St > 35

Profit -2 (St -30) - 2 3

For the vertical bear put spread:

Stock price St ≤ 30 30 < St ≤ 35 St > 35

Profit 2 (30-St ) + 2 -3

Graphicall illustration of Bull put spread:

30

20

10
profit
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 short put
-10
long put
-20

-30

-40
Seminar 9 – Problem 4 Decembre 1, 2014

Graphicall illustration of Bear put spread:

40

30

20
profit
10
short put
0
long put
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45
-10

-20

-30

Profit and spreads for individual prices and strategies are summarized in following
table.

BULL PUT SPREAD BEAR PUT SPREAD

stock
price profit short put long put profit short put long put
0 -2 -28 26 2 -26 28
1 -2 -27 25 2 -25 27
2 -2 -26 24 2 -24 26
3 -2 -25 23 2 -23 25
4 -2 -24 22 2 -22 24
5 -2 -23 21 2 -21 23
6 -2 -22 20 2 -20 22
7 -2 -21 19 2 -19 21
8 -2 -20 18 2 -18 20
9 -2 -19 17 2 -17 19
10 -2 -18 16 2 -16 18
11 -2 -17 15 2 -15 17
12 -2 -16 14 2 -14 16
13 -2 -15 13 2 -13 15
14 -2 -14 12 2 -12 14
15 -2 -13 11 2 -11 13
16 -2 -12 10 2 -10 12
17 -2 -11 9 2 -9 11
18 -2 -10 8 2 -8 10
19 -2 -9 7 2 -7 9
20 -2 -8 6 2 -6 8
21 -2 -7 5 2 -5 7
22 -2 -6 4 2 -4 6
23 -2 -5 3 2 -3 5
Seminar 9 – Problem 4 Decembre 1, 2014

24 -2 -4 2 2 -2 4
25 -2 -3 1 2 -1 3
26 -2 -2 0 2 0 2
27 -2 -1 -1 2 1 1
28 -2 0 -2 2 2 0
29 -2 1 -3 2 3 -1
30 -2 2 -4 2 4 -2
31 -1 3 -4 1 4 -3
32 0 4 -4 0 4 -4
33 1 5 -4 -1 4 -5
34 2 6 -4 -2 4 -6
35 3 7 -4 -3 4 -7
36 3 7 -4 -3 4 -7
37 3 7 -4 -3 4 -7
38 3 7 -4 -3 4 -7
39 3 7 -4 -3 4 -7
40 3 7 -4 -3 4 -7
41 3 7 -4 -3 4 -7
42 3 7 -4 -3 4 -7
43 3 7 -4 -3 4 -7
44 3 7 -4 -3 4 -7
45 3 7 -4 -3 4 -7
Seminar 9
Group 29 (aleksaradosavcevic@gmail.com)

Problem 5: A call with a strike price of $60 costs $6. A put with the same strike
price and expiration date costs $4.

1. Construct a table that shows the profit from a straddle.

2. For what range of stock prices would the straddle lead to a loss?

Solution:

1) Straddle is the combination of a call option and a put option on the same
security, with the same exercise price and the same expiry date.

Buyer of a straddle is expecting a big jump in share prices but is not sure of the
direction(he makes a profit if the underlying moves far enough in either direction in
return for paying two premiums).

Seller of a straddle is expecting little or no change in share prices (he benefits if

volatility is low).

In our case:

Stock price Call Payoff Put Payoff Profit

St ≤ 60 0 60 - St 60-10- St=60- St
St > 60 St - 60 0 St - 60 -10= St-70

2) We paid for these two option premiums: $4 (put) + $6 (call) = $10, therefore
we will make a loss if the share price will be between $50 and $70 on expiry
date.