Mini Case (c - f)

Assume that you have just been hired as a financial analyst by Triple Play Inc., a mid sized
California company that specialises in creating high fashion clothing.
Question (c)
Consider Triple Play's call option with a $25 strike price.
The following table contains historical values for this option at different stock prices:

Stock Price
($)
$
25.00
$
30.00
$
35.00
$
40.00
$
45.00
$
50.00

$
$
$
$
$
$

Stock Price,
St ($)
$
25.00
$
30.00
$
35.00
$
40.00
$
45.00
$
50.00

Strike Price,
K ($)
$
25.00
$
25.00
$
25.00
$
25.00
$
25.00
$
25.00

(1) Create a table that shows:

Call Option
Price ($)
3.00
7.50
12.00
16.50
21.00
25.50

(a) stock price

(b) strike price
(c) exercise value/intrinsic value
(d) option price and
(e) time vale, which is the option's pricess less its exercise
value

Intrinsic
Value ($)
$
$
5.00
$
10.00
$
15.00
$
20.00
$
25.00

$
$
$
$
$
$

Call Option
Time
Price ($)
Value ($)
3.00 $
3.00
7.50 $
2.50
12.00 $
2.00
16.50 $
1.50
21.00 $
1.00
25.50 $
0.50

(2) What happens to the time value as the stock price rises? Why?
As the stock price rises that time value is decreasing. This is because in
general, the more time to expiration, the greater the time value of the
option. It represents the amount of time that the option position has to
become more profitable due to a favorable move in the underlying price. In
general, investors are willing to pay a higher premium for more time
(assuming the different options have the same exercise price), since time
increases the likelihood that the position can become profitable.

Mini Case (c - f)
Assume that you have just been hired as a financial analyst by Triple Play Inc., a mid sized California company that
specialises in creating high fashion clothing.
Question (d)
Consider a stock with a current price of P = $27. Suppose that over the next 6 monts the stock price will either go up by a
factor of 1.41 or down by a factor of 0.71. Consider a call option on the stock with a strike price of $25 that expires in 6
months. The risk-free rate is 6%
(1) Using the binomial model, what are the ending values of the stock price? What are the pay offs of the call option?
So
T (in years)
u
d
K
rf

27.00
0.5
1.41
0.71
25.00
0.06

t=0
So =

27.00

t=0
So = unknown

t=1
So x u = $
So x d = $

38.07
19.17

t=1
Cu=Max(Sou - K,0) $

13.07

Cd=Max(Sod - K,0) $

(2) Suppose you write 1 call option and buy Ns shares of stock. How many shares must you buy to create a portfolio with a
riskless payoff (i.e a hedge portfolio)? What is the payoff of the portfolio?
=

0.6915343915
0.70
t=0
Ho = $

12.86

t=1
Ho x u = $
Ho x d = $

13.26
13.26

(3) What is the present value of the hedge portfolio? What is the value of the call option?
Current Value of
$
12.86
Hedge Portfolio, Ho
Co = Delta*So - Ho

5.81

(4) What is a replicating portfolio? What is arbitrage?

Replicating Portfolio - an asset portfolio consiting of
- real assets with liquid market prices
- real illiquid assets
- theorectical assets

Arbitrageis the process of exploiting differences in the price of anassetby simultaneously buying and selling it. In the process the
arbitrageur pockets arisk-free return. Differences in prices usually occur because of imperfect dissemination of information.

Mini Case (c - f)
Assume that you have just been hired as a financial analyst by Triple Play Inc., a mid sized California company that
specialises in creating high fashion clothing.
Question (e)
In 1973, Fischer Black and Myron Scholes developed the Black-Scholes options pricing model (OPM)
(1) What assumptions underlie the OPM?
1) European Option: assumes that the option can only be exercised at expiration
2) No dividends are paid out during the life of the option
3) Constant Volatility: measure of how much a stock can be expected to move in the near term. While volatility can be relatively constant in a
very short term, it is never constant in the longer term.
4) Efficient markets. This assumption of the Black-Scholes model suggests that people cannot consistently predict the direction of the market
or an individual stock. The Black-Scholes model assumes stocks move in a manner referred to as a random walk. Random walk means that at
any given moment in time, the price of the underlying stock can go up or down with the same probability. The price of a stock in time t+1 is
independent from the price in time t.
5) Interest rates constant and known. The same like with the volatility, interest rates are also assumed to be constant in the Black-Scholes
model. The Black-Scholes model uses the risk-free rate to represent this constant and known rate. In the real world, there is no such thing as
a risk-free rate, but it is possible to use the U.S. Government Treasury Bills 30-day rate since the U. S. government is deemed to be credible
enough. However, these treasury rates can change in times of increased volatility.
6) Lognormally distributed returns. The Black-Scholes model assumes that returns on the underlying stock are normally distributed. This
assumption is reasonable in the real world.
7) No commissions and transaction costs. The Black-Scholes model assumes that there are no fees for buying and selling options and stocks
and no barriers to trading.
8) Liquidity. The Black-Scholes model assumes that markets are perfectly liquid and it is possible to purchase or sell any amount of stock or
options or their fractions at any given time.
(2) Three equations that constitute the model

(3) According to the OPM, what is the value of a call option with the following characteristics?
Stock price
$
27.00
Strike price
$
25.00
Time to expiration
0.5
Risk-free rate
0.06
Stock return
0.49
standard deviation
d1
d2
Ct

0.4531980588
0.106715736
$

5.06

N(d1)
N(d2)

0.67479693
0.54249275

Mini Case (c - f)
Assume that you have just been hired as a financial analyst by Triple Play Inc., a mid sized California company that specialises i
creating high fashion clothing.

Question (f)
What impact foes each of the following parameters have on the value of a call option?
1) Current stock price
Impact on Intrinsic Value. A call gives you the right to buy the stock, therefore an individual would be willing
more for the call option if the stock price increases (preferably above the exercise price)
2) Strike price

Impact on Intrinsic Value. Once again call gives right to buy a stock at a given exercise price. Therefore as th
exercise price reduces (your cost to purchase the stock) the value of the call is greater. I.e. Intrinsic Value =
- K). The greater the +ve difference b/w S and K, the higher value of call option

3) Option's term to maturity

4) Risk-free rate

Longer expiration improves odds of option ending up inthemoney or odds of giving a higher payoff.
When risk free rates (interest rates) are higher opportunity costs of holding money is higher. By using call op
investors save more money by not paying for the underlying until later date and earn higher interest meanw

5) Variability of the stock price Affects the chances that the option will end up inthemoney and the chances of a greater option
payoff (positive impact)

a company that specialises in

re an individual would be willing to pay

ercise price)

n exercise price. Therefore as the

is greater. I.e. Intrinsic Value = Max (0, S
on

of giving a higher payoff.

money is higher. By using call options
and earn higher interest meanwhile.

s of a greater option