CHAPTER 11
Properties of Stock Options
Problem 1.
List the six factors affecting stock option prices.
The six factors affecting stock option prices are the stock price, strike price, risk-free interest
rate, volatility, time to maturity, and dividends.
Problem 2.
What is a lower bound for the price of a four-month call option on a non-dividend-paying
stock when the stock price is $28, the strike price is $25, and the risk-free interest rate is 8%
per annum?
Note that the exercise value of the call if it is American: 28-25 = 3
The lower bound (intrinsic value) is
Problem 3.
What is a lower bound for the price of a one-month European put option on a non-dividend-
paying stock when the stock price is $12, the strike price is $15, and the risk-free interest rate
is 6% per annum?
The lower bound is
Note that the exercise value of the put if it is American: 15-12 = 3
Problem 4.
Give two reasons that the early exercise of an American call option on a non-dividend-paying
stock is not optimal. The first reason should involve the time value of money. The second
reason should apply even if interest rates are zero.
Delaying exercise delays the payment of the strike price. This means that the option holder is
able to earn interest on the strike price for a longer period of time. Delaying exercise (keeps
the option alive, preserve the speculative value of the option) also provides insurance against
the stock price falling below the strike price by the expiration date. Assume that the option
holder has an amount of cash and that interest rates are zero. When the option is exercised
early it is worth at expiration. Delaying exercise means that it will be worth
at expiration. Keep the time/speculative value of the option.
Problem 5.
The price of a non-dividend paying stock is $19 and the price of a three-month European call
option on the stock with a strike price of $20 is $1. The risk-free rate is 4% per annum. What
is the price of a three-month European put option with a strike price of $20?
Note that Put-call-parity is directly applicable only when both the European put and call share
an identical exercise price.
In this case, , , , , and . From put–call parity
Protective put: P + S = c + PV(X) : call + bond = GIC(S,X)
so that the European put price is $1.80.
or
C = put + ex-dividend share price – PV(X)
Problem 6.
A four-month European call option on a dividend-paying stock is currently selling for $5. The
stock price is $64, the strike price is $60, and a dividend of $0.80 is expected in one month.
The risk-free interest rate is 12% per annum for all maturities. What opportunities are there
for an arbitrageur? Table the transactions and cash flows associated with your arbitrage
strategy.
The present value of the strike price is . The present value of the
dividend is . Because
Lower bound for call: C > [ S - PV(D) ] - PV(X)
5 < (64 – 0.79) – 57.65 = 5.56
Call price is below its lower boundary value
Buy low, short high
Buy call for 5, short stock for 64, invest 0.79 in a 1-month riskfree asset (at 1-month rate),
investment 57.65 in a 4-month riskfree asset (4-month rate),
the condition in equation (11.8) is violated. An arbitrageur should buy the option and short
the stock. This generates . The arbitrageur invests $0.79 of this at 12% for one
month to pay the dividend of $0.80 in one month (to compensate the stock lender the
dividend payment). The remaining $58.21 is invested for four months at 12% (to deal with
potential exercise). Regardless of what happens a profit will materialize.
If the stock price declines below $60 in four months, the arbitrageur loses the $5 spent on the
option but gains on the short position. The arbitrageur shorts when the stock price is $64, has
to pay dividends with a present value of $0.79, and closes out the short position when the
stock price is $60 or less. Because $57.65 is the present value of $60, the short position
generates at least in present value terms. The present value of the
arbitrageur’s gain is therefore at least .
If the stock price is above $60 at the expiration of the option, the option is exercised. The
arbitrageur buys the stock for $60 in four months and closes out the short position. The
present value of the $60 paid for the stock is $57.65 and as before the dividend has a present
value of $0.79. The gain from the short position and the exercise of the option is therefore
exactly . The arbitrageur’s gain in present value terms is exactly
.
Transactions CF today CF intermediate day Expiration day
S>X S<X
Should the arbitrage profit be equal to 5.56 – 5 = 0.56?
Lower bound is 5, the call price can be higher than 5. If the price of the call is indeed greater
than 5, then the arbitrage operation will produce a minimum of 0.56.
Problem 7.
The price of a European call that expires in six months and has a strike price of $30 is $2.
The underlying stock price is $29, and a dividend of $0.50 is expected in two months and
again in five months. The term structure is flat, with all risk-free interest rates being 10%.
What is the price of a European put option that expires in six months and has a strike price of
$30?
Using the notation in the chapter, put-call parity [equation (10.10)] gives
or
In this case
In other words the put price is $2.51.
