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This document contains the solutions to homework problems from a financial engineering course. It addresses questions about calculating the lower bounds of call and put option prices given stock prices, strike prices, and interest rates. It also covers option hedging strategies, using futures contracts to adjust a portfolio's beta, and identifying arbitrage opportunities between European call and put options.

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Vakax Khan Sikandari
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2K views

Finance File

This document contains the solutions to homework problems from a financial engineering course. It addresses questions about calculating the lower bounds of call and put option prices given stock prices, strike prices, and interest rates. It also covers option hedging strategies, using futures contracts to adjust a portfolio's beta, and identifying arbitrage opportunities between European call and put options.

Uploaded by

Vakax Khan Sikandari
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PDF, TXT or read online on Scribd
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Econ 236: Financial Engineering

Professor Ai-ru (Meg) Cheng


Homework I

1. What is the lower bound for the price of a 6-month call option on a non-dividend-
paying stock when the stock price is $80, the strike price is $75, and the risk-free
interest rate is 10% per annum?
ANS:
The lower bound of this call option is

St − Ke−rτ = 80 − 75e−0.1(0.5)
= 8.86

2. What is a lower bound for the price of a 2-month European put option on a non-
dividend-paying stock when the stock price is $58, the strike price is $65, and the
risk-free rate is 5% per annum?
ANS:
The lower bound for this put option is

Ke−rτ − St = 65e−0.05(2/12) − 58
= 6.46

3. The price of a stock is $40. The price of a 1-year European put option on the
stock with a strike price of $30 is quoted as $7 and the price of a 1-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 buy 100 put options. Draw a
diagram illustrating how the investor’s profit or loss varies with the stock price over
the next year.
ANS:
See the attached figure.

4. A trader owns gold as part of a long-term portfolio. The trader can buy gold for
$550 per ounce and sell it for $548 per ounce. The trader can borrow at 6% per year
and invest funds at 5.5% per year. For what range of 1-year forward prices of gold
does the trader have no arbitrage opportunities?
ANS:
548e0.055 < Ft < 550e0.06
578.98 < Ft < 584.01

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5. A stock is expected to pay a dividend $1 per share in 2 months and in 5 months.
The stock price is $50, and the risk-free rate is 8% per annum. An investor has just
taken a short position in a 6-month forward contract on the stock.
a) What is the forward price?
ANS:
Ft = ((S − D)er(2/12) − D)er(3/12) er(1/12)
Ft = 48.98.
b) Suppose 3 months later, the price of the stock is $48 and the risk-free rate of
interest is still 8% per annum. What is the forward price? What is the value of the
short position in the forward contract?
ANS:
Ft+3/12 = (S − D)er(3/12)
Ft+3/12 = 47.95.
ft+3/12 = (Ft − Ft+3/12 )e−r(3/12)
ft+3/12 = (49.98 − 47.95)e−0.02 = 1.9898.

6. It is July 16. A company has a portfolio of stocks worth $100 million. The β of the
portfolio is 1.2. The company would like to use the CME December futures contract
on the S&P 500 to change the β of the portfolio to 0.5 during the period July 16 to
November 16. The index futures price is 1000, and each contract is on $250 times the
index.
a) What position the company should take?
ANS:
N = −(1.2 − 0.5)(100, 000, 000)/(1, 000 ∗ 250) = −280, the company should take a
short position in 280 futures contracts.
b) Suppose the company decides to increase the β from 1.2 to 1.5. What positions in
futures contracts should it take? ANS:
N = −(1.2 − 1.5)(100, 000, 000)/(1, 000 ∗ 250) = 120, the company should take a long
position in futures contracts.

7. A fund manager has a portfolio worth 50 million with a β of 0.87. The manager
is concerned about the market performance over the next 2 months and plans to use
3-month futures contracts on the S&P 500 to hedge the risk. The current level of the
index is 1250, one contract is on 250 times the index., the risk-free rate is 6% per
annum, and the dividend yield on the index is 3%. The futures price is 1259. What
position should the manager take to hedge all exposure to the market over the next
2 months?
ANS:
N = −(0.87 − 0)(50.000, 000)/(1259 ∗ 250) = −138.2, the manager should take short
futures position.

2
8. A European call option and put option on a stock both have a strike price of $20
and an expiration date in 3 months. Both sell for $3. The risk-free interest rate is
10% per annum, the current stock price is $19, and a $1 dividend is expected in 1
month. Identify the arbitrage opportunity open to a trader.
ANS:
One strategy for exploiting the arbitrage opportunity is to
At time t:

• short a call

• buy a put

• borrow St dollars to buy a share of stock

At the maturity
When ST < K:

• gain −max(ST − K, 0) = 0 from short call position

• gain K − ST from long put position

• sell the stock at gain ST

• gain $1 from dividend yield

• total: gain K = 20

• net profit: K + 1e0.1/6 − St e0.1/4 = $1.54

When ST > K:

• gain K − ST from short position

• gain 0 from put position

• gain ST from selling the share

• gain $1 from dividend

• total: K = 20

• net profit: $1.54.

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