THE UNIVERSITY OF IOWA

College of Liberal Arts and Sciences

Department of Statistics and Actuarial Science

ACTS:4130

Quantitative Methods for Actuaries

Assignment 4 (Fall 2014)
(5% of your total scores)
Instructor : Ambrose Lo
Grader : Yao Chen

INSTRUCTIONS
1. This assignment covers the material in Chapter 5.3 and Chapter 6 and consists of 10 questions
numbered 1 through 10 for a total of 90 points. The points for each question are indicated at
the beginning of the question.
2. Answer ALL TEN questions.
3. Remember to write your name and staple your work.
4. Hand in your work at the beginning of class on November 19, 2014 (Wednesday). Late work
will be penalized as follows:
Work submitted before the end of class on November 19, 2014 will receive a penalty of
50% of your scores (e.g. If you score 80, your effective score will be 40.)
Work submitted after the end of class on November 19, 2014 will receive zero scores.
5. You are welcome to discuss assignment problems with me during my office hours. You are
also encouraged to discuss homework problems with other students. However, what you hand
in must ultimately be your own work.

** BEGINNING OF ASSIGNMENT 4 **
1. (15 points) Assignment 3 Question 12

2. (Derivatives Markets, Problem 9.1: Warm-up) (5 points) A stock currently sells for $32.00.
A 6-month call option with a strike of $35.00 has a premium of $2.27. Assuming a 4%
continuously compounded risk-free rate and a 6% continuous dividend yield, what is the
price of the associated put option?

3. (Gap options) (11 points) A gap call option is a European call option whose payoff at maturity time T is given by
(
ST K1 , if ST > K2 ,
Payoff =
0,
if ST K2 ,
where ST is the time-T price of the underlying stock with a continuous dividend yield of , K1
and K2 are positive constants, called the strike price and trigger price respectively. Similarly,
the payoff of a European gap put option with strike price K1 and trigger price K2 is given by
(
K1 ST , if ST < K2 ,
Payoff =
0,
if ST K2 .
(a) (4 points) Sketch the payoff diagrams of the above gap call option in each of the following cases:
(i) K1 < K2
(ii) K1 K2
gap

gap

(b) (7 points) Let Ct and Pt denote the time-t prices of a European gap call and gap put
option respectively, both with strike price K1 and trigger price K2 and r be the continuously compounded risk-free interest rate. Prove, by no-arbitrage arguments, that
gap

Ct

gap

Pt

= St e (T t) K er(T t) .

Identify K .

4. (Derivatives Markets, Problem 9.16 (Adapted)) (10 points) You are given:
(i) The quoted ask (resp. bid) prices of a K-strike T -year call option and a K-strike T -year
put option on the same stock are denoted by Ca (K, T ) and Pa (K, T ) (resp. Cb (K, T ) and
Pb (K, T )) respectively.
(ii) The current ask and bid prices for the stock are S0a and S0b respectively.
(iii) You can borrow at the rate rB and lend at the rate rL .
(iv) The stock pays continuous dividends at a dividend yield of .
Use no-arbitrage arguments to derive condition(s), in terms of the above symbols, under
which you cannot profitably perform a parity arbitrage.

ACTS:4130 (22S:174) Fall 2014

Assignment 4

-2-

GO ON TO NEXT PAGE

5. (Challenging: American put-call inequality) (12 points) The current price of a stock is S0 .
The stock pays dividends continuously at a rate proportional to its price. The dividend yield
is . The continuously compounded risk-free interest rate is r. Let CA and PA be the time-0
prices of T -year K-strike American call and put options on the stock respectively.
Use no-arbitrage arguments to prove that
S0 e T K CA PA .
(Hint: Engage in the usual buy-low, sell-high strategy.)
(Hint of the hint: You have to take into account whether your counterparty exercises his/her
American option(s).)
(Hint of the hint of the hint: If your counterparty does exercise, think about how to remove
the resulting cash flows via an appropriate position in stock and/or borrowing/lending.)

6. (Challenging: Arbitrage with chooser option) (12 points) Consider a chooser option (also
known as an as-you-like-it option) on a nondividend-paying stock. At time 1, its holder will
choose whether it becomes a European call option or a European put option, each of which
will expire at time 3 with a strike price of $18.
The chooser option price is $6 at time t = 0.
The stock price is $20 at time t = 0. Let C(T ) and P(T ) denote respectively the prices of a
European call option and a European put option at time t = 0 on the stock expiring at time T ,
T > 0, with a strike price of $18.
You are given:
(i) The continuously compounded risk-free interest rate is 0.
(ii) P(1) = $1.04.
(iii) C(3) = $4.33.
Describe actions you could take at t = 0 and t = 1 using the chooser option and/or the options
in (ii) and (iii) only to exploit an arbitrage opportunity. Verify carefully that your trading
strategy is indeed an arbitrage, i.e. your cash flows at all times are always non-negative and
sometimes strictly positive.
(Hint: Refer to the intermediate derivations in Case Study 2.)

ACTS:4130 (22S:174) Fall 2014

Assignment 4

-3-

GO ON TO NEXT PAGE

7. (Derivatives Markets, Problem 9.4) (5 points) Suppose the exchange rate is 0.95 $/B
C, the
euro-denominated continuously compounded interest rate is 4%, the dollar-denominated continuously compounded interest rate is 6%, and the price of a 1-year 0.93-strike European call
on the euro is $0.0571.
What is the price of a 0.93-strike European put?
8. (Derivatives Markets, Problem 9.5) (5 points) The premium of a 100-strike yen-denominated
put on the euro is U8.763. The current exchange rate is 95U/B
C.
What is the strike of the corresponding euro-denominated yen call, and what is its premium?
9. (ACTS:4130 Fall 2012, Spring 2013 Midterm 2) (7 points) You are given:
The current dollar-euro exchange rate is $2.7/B
C.
A 10-year dollar-denominated European call option on B
C1 with a strike price of $2.50
sells for $0.34.
The continuously compounded risk-free interest rate on dollars is 1%.
The continuously compounded risk-free interest rate on euros is 3%.
Calculate the price of a 10-year euro-denominated European call option on $1 with a strike
price of B
C0.40.
10. (Derivatives Markets, Problem 9.7 b: Currency parity arbitrage) (8 points) You are given:
(i) The spot exchange rate is 0.009 $/.
(ii) The continuously compounded interest rate on dollars is 5%.
(iii) The continuously compounded interest rate on yen is 1%.
(iv) The price of a dollar-denominated European call on yen with 1 year to expiration and a
strike price of $0.009 is $0.0006.
(v) The price of a dollar-denominated European put on yen with 1 year to expiration and a
strike price of $0.009 is $0.0004.
Describe actions you could take at time 0 to exploit an arbitrage opportunity, and calculate
the arbitrage profit at time 0 in dollars.

** END OF ASSIGNMENT 4 **

ACTS:4130 (22S:174) Fall 2014

Assignment 4

-4-

STOP

Suggested solutions to ACTS:4130 (22S:174) Assignment 4

1. Solution.

(a) We first compute the spot rates:

(i) r0 (0, 1):

[1 + r0 (0, 1)][1 + r0 (1, 5)]4 = [1 + r0 (0, 4)]4 [1 + r0 (4, 5)]
[1 + r0 (0, 1)](1.063)4 = 1.0514 (1.065)
r0 (0, 1) = 1.771790%.
(ii) r0 (0, 2):
[1 + r0 (0, 2)]2 [1 + r0 (2, 5)]3 = [1 + r0 (0, 4)]4 [1 + r0 (4, 5)]
[1 + r0 (0, 2)]2 1.0553 = 1.0514 (1.065)
r0 (0, 2) = 5.196562%.
(iii) r0 (0, 3):
[1 + r0 (0, 3)]3 = [1 + r0 (0, 2)]2 [1 + r0 (2, 3)]
r0 (0, 3) = 5.197708%.
(iv) r0 (0, 5):
[1 + r0 (0, 5)]5 = [1 + r0 (0, 4)]4 [1 + r0 (4, 5)] = 1.0514 (1.065)
r0 (0, 5) = 5.378520%.
The 5-year swap rate is
R =

1 P(0, 5)
5i=1 P(0, i)

1 1/1.05378525
1/1.01771790 + 1/1.051965622 + 1/1.051977083 + 1/1.0514 + 1/1.05378525

5.3167% .

(b) We first compute the remaining implied forward rates needed:

(i) r0 (1, 2):
[1 + r0 (0, 1)][1 + r0 (1, 2)] = [1 + r0 (0, 2)]2
1.01771790[1 + r0 (1, 2)] = 1.051965622
r0 (1, 2) = 8.7366%.
(ii) r0 (3, 4):
[1 + r0 (0, 3)]3 [1 + r0 (3, 4)] = [1 + r0 (0, 4)]4
1.0519773 [1 + r0 (3, 4)] = 1.0514
r0 (3, 4) = 4.8074%.
Psys implicit loan balance at the end of each of the five years is tabulated below:

ACTS:4130 (22S:174) Fall 2014

Assignment 4 Suggested Solutions

-5-

End of Year
r0 (i 1, i)
1
2
8.7366%
3
5.2% (given)
4
4.8074%
5
6.5% (given)

1, 000, 000[R r0 (i 1, i)] Implicit loan balance

35, 449
35, 449
34, 199
4, 347
1, 167
5, 740
5, 093
11, 109
11, 833
0

Remark 1. The loan balance at the end of Year 5 must be zero (or very close, due to
rounding errors). Otherwise, you must have made computational mistakes.
2. Solution. By put-call parity,
P(35, 0.5) = 2.27 32e0.06(0.5) + 35e0.04(0.5) = 5.5227 .
3. Solution.

(a) The payoff diagrams are shown below.

Payoff

Payoff

K2 K1

K1

K2

ST

K2

K1

ST

K2 K1
Figure 1: The payoff diagram of a gap European call option when (i) K1 < K2 (left) and (ii)
K1 K2 (right).

Remark 2. It is possible for the payoff of a gap call to be negative.

(b) Consider the portfolio at time t of:
Buying a gap call
Selling a gap put
The payoff of this portfolio at expiration is always ST K1 , which is the same payoff
as buying e (T t) units of stock and borrowing K1 er(T t) at time t. The desired
conclusion follows from the no-arbitrage principle with K = K1 .
ACTS:4130 (22S:174) Fall 2014
Assignment 4 Suggested Solutions

-6-

Remark 3. There was a typo in the question. In the displayed equation of part (b), S0
should read S t .
4. Solution. The ordinary form of put-call parity reads
C(K, T ) P(K, T ) = S0 e T KerT .

(1)

Consider buying LHS and selling RHS:

Cash Flows
Transaction
t =0
t =T
a
Buy call
C (K, T ) (ST K)+
Sell put
+Pb (K, T ) (K ST )+
Sell e T units of stock +S0b e T
ST
r
T
r
T
L
L
Lend Ke
Ke
+K
Total
?
0
In the absence of arbitrage, the cash flow at t = 0 must be non-positive:
Ca (K, T ) + Pb (K, T ) + S0b e T KerL T 0.

(2)

Consider buying RHS and selling LHS:

Cash Flows
Transaction
t =0
t =T
b
Sell call
+C (K, T ) (ST K)+
Buy put
Pa (K, T ) (K ST )+

T
Buy e
units of stock S0a e T
ST
Borrow KerB T
KerB T
K
Total
?
0
Again, in the absence of arbitrage, the cash flow at t = 0 must be non-positive:
Cb (K, T ) Pa (K, T ) S0a e T + KerB T 0.

(3)

Remark 4. Of course, if Cb (K, T ) = Ca (K, T ), Pb (K, T ) = Pa (K, T ), S0b = S0a and rB = rL ,

then (2) and (3) become
C(K, T ) + P(K, T ) + S0 e T KerT 0
and
C(K, T ) P(K, T ) S0 e T + KerT 0,
which together yield the ordinary form of put-call parity given in (1).
5. Solution. To prove the inequality S0 e T K CA PA , we assume the contrary, i.e.
CA PA < S0 e T K.
Following the buy-low, sell-high strategy, we perform the following at time 0:
ACTS:4130 (22S:174) Fall 2014
Assignment 4 Suggested Solutions

-7-

(4)

(1) Buy the American call

(2) Sell the American put
(3) (Short) Sell e T units of stock
(4) Lend K
At time 0, we receive S0 e T K (CA PA ), which is positive because of (4).
Two separate cases need to be considered depending on whether the American put holder
exercises his/her put option.
Case 1.

If the put option is not exercised prior to expiration, then we do not exercise the
American call option early either. At time T , our payoff will be
rT
= (ST K) ST + KerT = K(erT 1),
(ST K)+ (K ST )+ ST + Ke
{z
} |{z} |{z}
| {z } |
(1)

(4)

(3)

(2)

which is always positive.

Case 2.

If the put option is exercised at some t [0, T ), then at time t, we:

(5) Borrow K
(6) Buy 1 unit of the stock
The time-t cash flow will be
(K St )
| {z }

Counterparty exercises put

+ |{z}
K St = 0.
|{z}
(5)

(6)

At time T , our payoff will be

rT
(ST K)+ ST + Ke
Ker(T t) + S e (T t)
| {z } |{z} |{z} | {z } | T {z }
(1)

(3)

(4)

(5)

(6)

= (ST K)+ + ST (e (T t) 1) + KerT (1 ert )

> 0.
Remark 5. If the loan we issue in (4) can be settled anytime before time T (note that
t cannot be predicted in advance), then Case 2 can also be dealt with as follows:
If the put option is exercised at some t [0, T ), then at time t, we close
our positions in (3) and (4) by:
(5) Repaying the stock
(6) Collecting the proceeds we lent at time 0
The time-t cash flow will be
(K St )
| {z }

Counterparty exercises put

St e (T t) + |{z}
Kert
|
{z
}
(5)

(6)

= K(ert 1) + St (1 e (T t) ) > 0.
In the mean time, we are still holding the American call option, hence
entitled to future cash inflows.
ACTS:4130 (22S:174) Fall 2014
Assignment 4 Suggested Solutions

-8-

In both cases, there are always positive cash flows at time 0 and after time 0. We have thus
designed an arbitrage strategy. As a result, (4) cannot be true, i.e. we must have
S0 e T K CA PA .
Remark 6. With essentially the same technique, we can prove that
CA PA S0 KerT .
Overall, we have the following upper and lower bounds on the difference between American
call and American put prices:
S0 e T K CA PA S0 KerT .
In other words, CA PA may not equal the difference given by put-call parity, which holds
only for European options. Note that the upper bound is always greater than the lower bound,
because
(S0 KerT ) (S0 e T K) = S0 (1 e T ) + K(1 erT ) > 0
when r > 0 or > 0.
6. Solution. By equation (2) of Case Study 2, the fair price of the chooser option is
C(20, 18, 3) + P(20, 18, 1) = C(3) + P(1) = 4.33 + 1.04 = 5.37,
which is less than the observed price. To take advantage of the mispricing, we:
(a) Sell the chooser option .
(b) Buy a 18-strike 1-year put option .
(c) Buy a 18-strike 3-year call option .
At t = 0, we receive 6 5.37 = 0.63 . At t = 1, if we sell the call option in Action (c) , then
the resulting cash flow will always be zero, because
max (C(S1 , 18, 2), P(S1 , 18, 2))
|
{z
}
Short chooser payoff in (a)

+C(S1 , 18, 2)
|
{z
}

from selling the call in (c)

(18 S )
| {z 1 +}

Long put payoff in (b)

= C(S1 , 18, 2) max (P(S1 , 18, 2) C(S1 , 18, 2), 0) +C(S1 , 18, 2) + (18 S1 )+
= (18 S1 )+ + (18 S1 )+
= 0.
We have thus constructed an arbitrage strategy.
7. Solution. By currency put-call parity,
r T
C + Ker$ T
P$ (0.95, 0.93) = C$ (0.95, 0.93) x0 e B
= 0.0571 0.95e0.04 + 0.93e0.06
= 0.0202 ,

i.e. the required put price is $0.0202.

ACTS:4130 (22S:174) Fall 2014
Assignment 4 Suggested Solutions

-9-

8. Solution. The strike of the corresponding euro-denominated yen call is B

C1/100 = B
C0.01 .
(Note: You need to specify the currency of the strike!)
By currency option put-call duality, the premium, in euros, is


1 1
1
1
1
1
CB
C 95 , 100 = 95 100 PU (95, 100) = 95 100 8.763 = 0.0009
9. Solution. First, by currency put-call parity,
P$ (2.7, 2.5) = 0.34 2.7e0.03(10) + 2.5e0.01(10) = 0.601884.
Then by currency put-call duality,


1
1
1
CB
C 2.7 , 0.4 = 2.7 2.5 P$ (2.7, 2.5) = 0.0892 .
Remark 7. This question is essentially a direct modification of Example 6.2.2 in the lecture
notes.
10. Solution. The LHS of the currency put-call parity is 0.0006 0.0004 = 0.0002, while its
RHS is
0.009e0.01 0.009e0.05 = 0.000349384.
To exploit an arbitrage strategy, we buy the LHS and sell the RHS by performing the following
actions:
Cash Flows
Transaction
Dollar
Yen
Buy the dollar-denominated European call
0.0006
0
Sell the dollar-denominated European put
0.0004
0
Lend / Buy $0.009e0.05
0.009e0.05
0
0.01
0.01
Borrow / Sell e
0
e
0.01
0.01
0.01
Use e
to exchange for $0.009e
0.009e
e0.01
Total
0.0001494
0
At time 0, we receive $0.0001494 . At time 1, the payoff is
($x1 $0.009)+ ($0.009 $x1 )+

$x
| {z }1

+$0.009
| {z }

= $0.

repay loan on yen get back proceeds in dollar

Remark 8. The last action in the above table allows us to express the arbitrage profit in dollars.

** END OF SOLUTIONS **

ACTS:4130 (22S:174) Fall 2014

Assignment 4 Suggested Solutions

-10-