INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.

COURSE: MBA-683-50-F12 Financial Engineering

cross-listed with FIN-410-50-F12 Derivative Securities
SEMESTER: I, 2012

Exercises Chapter 10
Trading Strategies Involving Options

Konstantinos Kanellopoulos
12th November 2012
PART I EXERCISES FROM CHAPTER 10

Exercise 1

Suppose that Mr. Colleoni borrows the present value of $100, buys a six-month put option on
stock Ywith an exercise price of $150, and sells a six-month put option on Y with an exercise
price of $50.
a. Draw a position diagram showing the payoffs when the options expire.
b. Suggest two other combinations of loans, options, and the underlying stock that
would give Mr. Colleoni the same payoffs.

Solution 1

a. The payoffs at expiration for the two options are shown in the following position
diagram:

Option value

150

100

50

50 100 150 Share price

-50

-100

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 Taking into account the $100 that must be repaid at expiration, the net
payoffs are:

Net payoff

150

100

50

50 100 150 Share price

-50

-100

b. Here we can use the put-call parity relationship:

Value of call + Present value of exercise price = Value of put + Share price
The value of Mr. Colleonis position is:
Value of put (EX = 150) Value of put (EX = 50) PV (150 50)
Using the put-call parity relationship, we find that this is equal to:
Value of call (EX = 150) Value of call (EX = 50)
Thus, one combination that gives Mr. Colleoni the same payoffs is:
Buy a call with an exercise price of $150
Sell a call with an exercise price of $50
Similarly, another combination with the same set of payoffs is:
Buy a put with an exercise price of $150
Buy a share of stock
Borrow the present value of $150
Sell a call with an exercise price of $50

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Exercise 2

Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $7 respectively.
How can the options be used to create (a) a bull spread and (b) a bear spread? Construct a table
that shows the profit and payoff for both spreads.

Solution 2
A bull spread is created by buying the $30 put and selling the $35 put. This strategy gives rise
to an initial cash inflow of $3. The outcome is as follows:

Stock price Payoff Profit

St>=35 0 3
30<=St<35 St-35 St-32
St<30 -5 -2

A bear spread is created by selling the $30 put and buing the $35 put. This strategy costs $3
initially. The outcome is as follows:

Stock price Payoff Profit

St>=35 0 -3
30<=St<35 35-St 32-St
St<30 5 2

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Exercise 3

Option traders often refer to straddles and butterflies. Here is an example of each:
Straddle: Buy call with exercise price of $100 and simultaneously buy put with exercise price
of $100.
Butterfly: Simultaneously buy one call with exercise price of $100, sell two calls with exercise
price of $110, and buy one call with exercise price of $120. Draw position diagrams for the
straddle and butterfly, showing the payoffs from the investors net position. Each strategy is a bet
on variability. Explain briefly the nature of each bet.

Solution 3

Straddle

Payoff
Payoff to put
100
Payoff to call
Calcall
Share price
100

Butterfly
Payoff

Payoff to buy call, Payoff to buy call,

EX = 100 EX = 120

Share price
100 120
Payoff to sell call,
EX = 110,sell two

The buyer of the straddle profits if the stock price moves substantially in either direction;
hence, the straddle is a bet on high variability. The buyer of the butterfly profits if the
stock price doesnt move very much, and hence, this is a bet on low variability.

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Exercise 4

In 1988 the Australian firm Bond Corporation sold a share in some land that it owned near Rome
for $110 million and as a result boosted its 1988 earnings by $74 million. In 1989 a television
program revealed that the buyer was given a put option to sell its share in the land back to Bond
for $110 million and that Bond had paid $20 million for a call option to repurchase the share in
the land for the same price.18
a. What happens if the land is worth more than $110 million when the options expire? What if it
is worth less than $110 million?
b. Use position diagrams to show the net effect of the land sale and the option transactions.
c. Assume a one-year maturity on the options. Can you deduce the interest rate?
d. The television program argued that it was misleading to record a profit on the sale of land.
What do you think?

Solution 4

a. If the land is worth more than $110 million, Bond will exercise its call option. If
the land is worth less than $110 million, the buyer will exercise its put option.

b. Bond has: (1) sold a share; (2) sold a put; and (3) purchased a call. Therefore:
Payoff

(3)

Price of land

(2)

(1)

This is equivalent to:

Payoff

Price of land

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c. The interest rate can be deduced using the put-call parity relationship. We know
that the call is worth $20, the exercise price is $110, and the combination [sell
share and sell put option] is worth $110. Therefore:
Value of call + Present value of exercise price = Value of put + Share price
Value of call + PV(EX) = Value of put + Share price
20 + [110/(1 + r)] = 110
r = 0.222 = 22.2%

d. From the answer to Part (a), we know that Bond will end up owning the land after
the expiration of the options. Thus, in an economic sense, the land has not really
been sold, and it seems misleading to declare a profit on a sale that did not really
take place. In effect, Bond has borrowed money, not sold an asset.

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Exercise 5

Three six-month call options are traded on Hogswill stock:

Exercise price Call Option Price

90 5
100 11
110 15

How would you make money by trading in Hogswill options? (Hint: Draw a graph with the
option price on the vertical axis and the ratio of stock price to exercise price on the horizontal
axis. Plot the three Hogswill options on your graph. Does this fit with what you know about how
option prices should vary with the ratio of stock price to exercise price?) Now look in the
newspaper at options with the same maturity but different exercise prices. Can you find any
money-making opportunities?

Solution 5

One way to profit from Hogswill options is to purchase the call options with exercise
prices of $90 and $110, respectively, and sell two call options with an exercise price of
$100. The immediate benefit is a cash inflow of:
(2 $11) ($5 + $15) = $2
Immediately prior to maturity, the value of this position and the net profit (at various
possible stock prices) is:
Stock Price Position Value Net Profit
85 0 0+2=2
90 0 0+2=2
95 5 5+2=7
100 10 10 + 2 = 12
105 5 5+2=7
110 0 0+2=2
115 0 0+2=2
Thus, no matter what the final stock price, we can make a profit trading in these Hogswill
options.
It is possible, but very unlikely, that you can identify such opportunities from data
published in the newspaper. Someone else has most likely already noticed (even before
the paper was printed, much less distributed to you) and traded on the information; such
trading tends to eliminate these profit opportunities.