soln ch 21 option val

7/29/2019 Soln Ch 21 Option Val

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CHAPTER 21: OPTION VALUATION

1. Put values also must increase as the volatility of the underlying stock increases. Wesee this from the parity relation as follows:

P = C + PV(X) S0 + PV(Dividends).

Given a value of S and a risk-free interest rate, if C increases because of an increasein volatility, so must P to keep the parity equation in balance.

2. a. Put A must be written on the lower-priced stock. Otherwise, given the lowervolatility of stock A, put A would sell for less than put B.

b. Put B must be written on the stock with lower price. This would explain its

higher value.

c. Call B must be written on the stock with lower time to expiration. Despite thehigher price of stock B, call B is cheaper than call A. This can be explained by alower time to expiration.

d. Call B must be written on the stock with higher volatility. This would explain itshigher price.

e. Call A must be written on the stock with higher volatility. This would explainthe higher option premium.

3. X Hedge ratio

115 85/150 = 0.567100 100/150 = 0.66775 125/150 = 0.83350 150/150 = 1.00025 150/150 = 1.00010 150/150 = 1.000

As the option becomes more in the money, its hedge ratio increases to a maximum of 1.0.

4. S dl N(dl)

45 .0268 .489350 .5000 .691555 .9766 .8356

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5. a. When ST is 130, P will be 0.

When ST is 80, P will be 30.

The hedge ratio is (P+ P)/(S+ S) = (0 30)/(130 80) = 3/5.

b. Riskless Portfolio S = 80 S = 130

3 shares 240 3905 puts 150 0Total 390 390

Present value = 390/1.10 = 354.545

c. The portfolio cost is 3S + 5P = 300 + 5P, and it is worth $354.545 . Therefore Pmust be 54.545/5 = $10.91.

6. The hedge ratio for the call is (C+ C)/(S+ S) = (20 0)/(130 80) = 2/5.

Riskless Portfolio S = 80 S = 130

2 shares 160 2605 calls written 0 100Total 160 160

5C + 200 = 160/1.10. Therefore, C = $10.91.

Does P = C + PV(X) S?

10.91 = 10.91 + 110/1.10 10010.91 = 10.91

7. d1 = .3182 N(d1) = .6248

d2 = .0354 N(d2) = .4859

Xe- rT = 47.56C = $8.13

8. P = $5.69.

This value is from our Black-Scholes spreadsheet, but note that we could havederived the value from put-call parity:

P = C + PV(X) S0 = 8.13 + 47.56 50 = $5.69

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9. a. C falls to 5.5541b. C falls to 4.7911c. C falls to 6.0778d. C rises to 11.5066e. C rises to 8.7187

10. According to the Black-Scholes model, the call option should be priced at

55 N(d1) 50 N(d2) = 55 .6 50 .5 = $8

Because the option actually sells for more than $8, implied volatility is higher than .30.

11. A straddle is a call and a put. The Black-Scholes value would be:

C + P = S0N(d1) XerT N(d2) + XerT [1 N(d2)] S0 [1 N(d1)]

= S0 [2 N(d1) 1] + XerT [1 2N(d2)]

On the Excel spreadsheet (Figure 21.8 in the text), the valuation formula would be:

B5*(2*E4 1) + B6*EXP(B4*B3)*(1 2*E5)

12. Less. The change in the call price would be $1 only if (i) there were 100%probability that the call would be exercised, and (ii) the interest rate were zero.

13. Holding firm-specific risk constant, higher beta implies higher total stock volatililty.Therefore, the value of the put option will increase as beta increases.

14. Holding beta constant, the high firm-specific risk stock will have higher totalvolatility. The option on the stock with higher firm-specific risk will be worth more.

15. Lower. The call option will be less in the money. Both d1 and N(d1) are lower when

X is higher.

16. More. The option elasticity exceeds 1.0. In other words, the option is effectively alevered investment and the rate of return on the option will be more sensitive tointerest rate swings.

17. Implied volatility has increased. If not, the call price would have fallen.

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18. Implied volatility has increased. If not, the put price would have fallen.

19. The hedge ratio approaches one. As S increases, the probability of exercise

approaches 1.0. N(d1) approaches 1.0.

20. The hedge ratio approaches 1.0. As S decreases, the probability of exerciseapproaches 1. [N(d1) 1] approaches 1 as N(d1) approaches 0.

21. The hedge ratio of the straddle is the sum of the hedge ratios of the individualoptions: .4 + (0.6) = 0.2.

22. a. The delta of the collar is calculated as follows:

Delta

Stock 1.0Put purchased (X = 45) N(d1) 1 = .40

Call written (X = 55) N(d1) = .35

Total .25

If the stock price increases by $1, the value of your position will increase by$.25. The stock will be worth $1 more, the loss on the purchased put will be$.40, and the call written will represent a liability that increases by $.35.

b. If S becomes very large, then the delta of the collar approaches zero. Both N(d1)

terms approach 1. Intuitively, for very large stock prices, the value of theportfolio is simply the (present value of the) exercise price of the call, and isunaffected by small changes in the stock price. As S approaches zero, the deltaalso approaches zero: both N(d1) terms approach 0. For very small stock prices,

the value of the portfolio is simply the (present value of the) exercise price of theput, and is unaffected by small changes in the stock price.

23. Statement a: The hedge ratio (determining the number of futures contracts to sell)

ought to be adjusted by the beta of the equity portfolio, which is given as 1.20. Theproper hedge ratio would be:

= 2,000 = 2,000 1.2 = 2,400

Statement b: The portfolio will be hedged, and therefore should earn the risk-freerate, not zero, as the consultant claims. Given a futures price of 100 and an equity

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price of 100, the rate of return over the 3-month period is (100 99)/99 = 1.01% orabout 4.1% annualized.

24. Put X Delta

A 10 .1B 20 .5C 30 .9

25. a. A. Calls have higher elasticity than shares. For equal dollar investments, acall's capital gain potential is higher than that of the underlying stock.

b. B. Calls have hedge ratios less than 1.0, so the shares have higher profitpotential. For an equal number of shares controlled, the dollar exposure of theshares is greater than that of the calls, and the profit potential is therefore

higher.

26. S = 100; current value of portfolioX = 100; floor promised to clients (0% return)

= .25; volatilityr = .05; risk-free rateT = 4 years; horizon of program

a. Using the Black-Scholes formula,we find that

d1= .65, N(d

1) = .7422, d

2= .15, N(d

2) = .5596

Therefore, put value = $10.27. Therefore, total funds to be managed are $110.27million: $100 million of portfolio value plus the $10.27 million fee for theinsurance program.

The put delta is N(d1) 1 = .7422 1 = .2578. Therefore, sell off 25.78% of

the equity portfolio, placing the remaining funds in bills. The amount of theportfolio in equity is therefore $74.22 million, while the amount in bills is$110.27 $74.22 = $36.05 million.

b. At the new portfolio value, the put delta becomes .2779, meaning that you mustreduce the delta of the portfolio by .2779 .2578 = .0201. You should sell anadditional 2.01% of the original equity position and use the proceeds to buy bills.Since the stock price is now at only 97% of its original value, you need to sell$97 million .0201 = $1.950 million worth of stock.

27. a. American options should cost more (have a higher premium). They give theinvestor greater flexibility than the European option since the investor can

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choose whether to exercise early. When the stock pays a dividend, the right toexercise a call early can be valuable. But regardless of dividends, a Europeanoption (put orcall) will neversell for more than an otherwise-identical Americanoption.

b. C = S0 + P PV(X) [no dividends seem to be paid]= 43 + 4 45/1.055 = $4.346

c. Short-term interest rate higher PV(exercise price) is lower, and call isworth more.

Higher volatility makes the call worth more.

Lower time to maturity makes the call worth less.

28. a. Stock Price Put Payoff 110 090 10

The hedge ratio is 0.5. A portfolio comprised of one share and two puts wouldprovide a guaranteed payoff of $110, with present value $110/1.05 = $104.76.Therefore,

S + 2P = 104.76100 + 2P = 104.76P = $2.38

b. The protective put strategy = 1 share + 1 put = $100 + $2.38 = $102.38

c. Our goal is a portfolio with the same exposure to the stock as the hypotheticalprotective put portfolio. As the puts hedge ratio is 0.5, we want to hold 1 0.5= 0.5 shares of stock, which costs $50, and place our remaining funds ($52.38)in bills, earning 5% interest.

Stock Price: 90 110Half share 45 55Bills 55 55Total 100 110

This payoff is exactly the same as that of the protective put portfolio. Thus, the stockplus bills strategy replicates both the cost and payoff of the protective put.

29. When r = 0, one should never exercise a put early. There is no time value cost towaiting to exercise, but there is a volatility benefit from waiting. To show thismore rigorously, consider this portfolio: lend $X and short one share of stock. The

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cost to establish the portfolio is X S0. The payoff at time T (with zero interest

earnings on the loan) is X ST. In contrast, a put option has a payoff at time T of

X STifthat value is positive, and zero otherwise. The puts payoff is at leastas

large as the portfolios, and therefore, the put must cost at least as much to purchase.Hence, P X S 0, and the put can be sold for more than the proceeds from

immediate exercise. We conclude that it doesnt pay to exercise early.

30. a. XerT

b. X

c. 0

d. 0

e. It obviously is optimal to exercise immediately a put on a stock whose price hasfallen to zero. The value of the American put equals the exercise price. Any

delay in exercise lowers value by the time value of money.

31. Step 1: Calculate the option values at expiration. The two possible stock prices are$120 and $80. Therefore, the corresponding two possible call values are $20 and $0.

Step 2: Find that the hedge ratio is (20 0)/(120 80) = .5. Therefore, form ariskless portfolio by buying one share of stock and writing two calls. The cost ofthe portfolio is S 2C = 100 2C.

Step 3: Show that the payoff of the riskless portfolio must equal $80. Therefore,

find the value of the call by solving

$100 2C = $80/1.10C = $13.636

Notice that we never used the probabilities of a stock price increase or decrease.These are not needed to value the call option.

32. The hedge ratio is (30 0)/(130 70) = .5. Form the riskless portfolio by buying oneshare of stock and writing two call options. The portfolio costs S 2C = 100 2C.The payoff of the riskless portfolio is $70. Therefore, 100 2C = 70/1.10, whichimplies that C = $18.182, which is greater than the value in the lower-volatilityscenario.

33. The hedge ratio for a put with X = 100 would be (0 20)/(120 80) = .5. Form theriskless portfolio by buying one share of stock and buying two put options. Theportfolio costs S + 2P = 100 + 2P. The payoff of the riskless portfolio is $120.Therefore, 100 + 2P = 120/1.10, which implies that P = $4.545. According to put-

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call parity, P + S = C + PV(X). Our estimates of option value satisfy thisrelationship: 4.545 + 100 = 13.636 + 100/1.10.

34. If one assumes that the only possible exercise date is just prior to the ex-dividenddate, the relevant parameters for the Black-Scholes formula are:

S0 = 60 r = .5% per month

X = 55 = 7%T = 2 months

In this case, C = $6.04.

If instead, one precommits to foregoing early exercise, one must reduce the stockprice by the present value of the dividends. Therefore, we use

S0 = 60 2e(.005

2)

= 58.02 r = .5% per monthX = 55 = 7%T = 3 months

In this case, C = $5.05. The pseudo-American option value is the higher of thesetwo values, $6.04.

35. a. (i)Index rises to 701. The combined portfolio will suffer a loss. The written callswill expire in the money; the protective put purchased will expire worthless. Letsanalyze on a per-share basis. The payout on each call option is $26, for a total cash

outflow of $52. The stock is worth $701. The portfolio thus ends up worth $701 $52 = $649. The net cost of the portfolio when the option positions were established

was: $668 + $8.05 (put) 2 $4.30 (calls written) = $667.45

(ii)Index remains at 668. Both options expire out of the money. The portfolio endsup worth $668 (per share), compared to an initial cost 30 days earlier of $667.45.The portfolio experiences a very small gain of $0.55.

(iii)Index declines to 635. The calls expire worthless. The portfolio will be worth$665, the exercise price of the protective put. This represents a very small loss of$2.45 compared to the initial cost 30 days earlier of $667.45.

b. (i)Index rises to 701. The delta of the call will approach 1.0 as the stock goes deepinto the money, while expiration of the call approaches and exercise becomesessentially certain. The put delta will approach zero.

(ii)Index remains at 668. Both options expire out of the money. Delta of each willapproach zero as expiration approaches and it becomes certain that the options willnot be exercised.

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(iii)Index declines to 635. The call is out of the money as expiration approaches.

Delta approaches zero. Conversely, the delta of the put approaches 1.0 as exercisebecomes certain.

c. The call sells at an implied volatility less than recent historical volatility; the put at a

higher implied volatility. The call seems relatively cheap; the put seems expensive.

36. True. The call option has an elasticity greater than 1.0. Therefore, the call's percentagereturns are greater than those of the underlying stock. Hence the GM call will respondmore than proportionately when the GM stock price changes along with broad marketmovements. Therefore, the beta of the GM call is greater than the beta of GM stock.

37. True. The elasticity of a call option is higher the more out of the money is theoption. (Even though the delta of the call is lower, the value of the call is also lower.Theproportional response of the call price to the stock price increases. You can

confirm this with numerical examples.) Therefore, the rate of return of the call withthe higher exercise price will respond more sensitively to changes in the marketindex. It will have the higher beta.

38. As the stock price increases, conversion becomes increasingly more assured. Thehedge ratio approaches 1.0. The convertible bond price will move one-for-one withchanges in the price of the underlying stock.

39. Salomon believes that the market assessment of volatility is too high. Therefore, itshould sell options because its analysis suggests the options are overpriced with

respect to true volatility. The delta of the call is .6, while that of the put is .6 1 = .4. Therefore, it should sell puts to calls in the ratio of .6 to .4. For example, if it sells2 calls and 3 puts, it will be delta neutral:

Delta = 2 .6 + 3 ( .4) = 0

40. Using a volatility of 32% and time to maturity T = .25 years, the hedge ratio forExxon is N(d1) = .5567. Because you believe the calls are underpriced (selling at

too low implied volatility), you will buy calls and short .5567 shares for each callthat you buy.

41. The calls are cheap (implied = .30) and the puts are expensive (implied = .34).

Therefore, buy calls and sell puts. Using the "true" volatility of = .32, the calldelta is .5567 and the put delta is .5567 1 = .4433. Therefore buy .5567/.4433 =1.256 puts for each call purchased.

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42. a. To calculate the hedge ratio, suppose that the market index increases by 1%.

Then the stock portfolio would be expected to increase by 1% 1.5 = 1.5%, or .

015 $1,250,000 = $18,750. Given the option delta of .8, the option portfolio

would increase by $18,750 .8 = $15,000 and Salomon's liability from writingthese options would increase by this amount. The futures price would increase by

1%, from 1,000 to 1,010. The 10-point gain would be multiplied by $250 toprovide a gain of $2,500 per contract. Therefore, Salomon would need to buy$15,000/$2,500 = 6 contracts to hedge its exposure.

b. The delta of a put option is .8 1 = 0.2. Therefore, for every 1% the marketincreases, the index will rise by 10 points and the value of the put option contract

will change by (delta 10 contract multiplier) = 0.2 10 100 = $200.Therefore, Salomon should write $12,000/$200 = 60 put contracts.

43. If the stock market index increases 1%, the 1 million shares of stock on which the

options are written would be expected to increase by .75% $5 1 million = $37,500.The options would increase by delta $37,500 = .8 $37,500 = $30,000. The futuresprice will increase by 10 points from 1,000 to 1,010, providing a profit per contract of

10 $250 = $2,500. You need to sell $30,000/$2,500 = 12 contracts to hedge againstthe possibility of a market decline.

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soln ch 21 option val

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