Timo Reichmann: Tutorial 3 FoF Solution

Institute for Law and Finance

Fundamentals of Finance - Tutorial III

Winter Term 2023/2024

1. Put-Call-Parity

Assume that a European Call Option with one year to expiration and a strike price of 88€ sells for
𝐶0 = 6 €. The current stock price is 𝑆0 = 85 €, and the (discrete) risk-free interest rate is 5% p.a.
What is the value of a European Put with same strike and maturity using the Put-Call-Parity?

Valuation of European Stock Options using the Put-Call-Parity:

Now, start from the Put-Call-Parity Equation and solve for 𝑃 since all other inputs are given:

88
𝐶0 − 𝑃0 = 𝑆0 − 𝑃𝑉(𝑋) ⟺ 𝑃0 = 𝑃𝑉(𝑋) − 𝑆0 + 𝐶0 ⟺ 𝑃0 = − 85 + 6 = 4,8095
1,05
Timo Reichmann: Tutorial 3 FoF Solution

2. One-Period Binomial Tree: Replication

Assume that each period, the non-dividend paying stock of “ILF-AG” can either increase or fall by 10%
in value, that is, 𝑢 = 1,1 , 𝑑 = 0,9. The initial price of the stock is €25 per share and the (discrete)
risk-free rate is 5% per period. Compute the value of a European Call Option with a strike price of €25
and maturity in 1 period, using a replication strategy.

First, we can draw the binomial tree, which is also very helpful to get an overview over what exactly is happening
in the exercise:

𝑆𝑢 = 𝑆0 𝑢 = 27,5
𝑅𝐹𝑈 = 1,05
𝐶𝑈 = max(27,5 − 25 ; 0) = 2,50
𝑆0 = 25
𝑅𝐹𝐼 = 1
𝐶0 =? 𝑆𝑑 = 𝑆0 𝑑 = 22,5
𝑅𝐹𝑑 = 1,05
𝐶𝑑 = max(22,5 − 25 ; 0) = 0

Now we can state the inhomogeneous linear system of equations considering the duplication portfolio which
replicates the Call Option payoff in every state:

𝐵 ∗ (1 + 𝑟𝑓 ) + Δ𝑆𝑑 = 𝐶𝑑 = 0
{
𝐵 ∗ (1 + 𝑟𝑓 ) + Δ𝑆𝑢 = 𝐶𝑢 = 2,50

Subtracting the second from the first equation yields:

𝐶𝑢 − 𝐶𝑑 2,50 − 0
Δ(𝑆𝑢 − 𝑆𝑑 ) = 𝐶𝑢 − 𝐶𝑑 ⇔ Δ = = = 0,5
𝑆𝑢 − 𝑆𝑑 27,50 − 22,50

𝐶𝑢 − Δ ∗ 𝑆𝑢 2,50 − 0,50 ∗ 27,50

𝐵= = = −10,7143
1 + 𝑟𝑓 1,05

So we buy 0,5 shares of the stock and we take a credit of 10,7143 (money units) that we pay back at the date of
maturity.

The searched Call Price then can be found as:

C0 = Δ𝑆0 + 𝐵 = 0,5 ∗ 25 − 10,7143 = 1,7857

 Timo Reichmann: Tutorial 3 FoF Solution

3. Binomial Trees: Valuing European Options

Assume that each period, the non-dividend paying stock of “HoF-AG” can either increase or fall by 30%
in value, that is, 𝑑 = 0,70 , 𝑢 = 1,30. The initial price of the stock is 50€ per share and the risk-free
rate is 6% per period. Compute the value of a European Put Option with a strike price of 47,50€ and
maturity in 2 periods, using risk-neutral valuation.

𝑆𝑢𝑢 = 𝑆0 𝑢2 = 84,5
𝑆𝑢 = 𝑆0 𝑢 = 65 𝑃𝑈𝑈 = 0
𝑷𝑼 = 𝟎, 𝟕𝟓𝟒𝟕 I.

𝑆0 = 50 𝑆𝑢𝑑 = 𝑆0 𝑢𝑑 = 45,5
III.
𝑷𝟎 = 𝟒, 𝟏𝟐𝟗𝟔 𝑃𝑢𝑑 = 2

𝑆𝑑 = 𝑆0 𝑑 = 35 II.
𝑷𝒅 = 𝟗, 𝟖𝟏𝟏𝟑
𝑆𝑑𝑑 = 𝑆0 𝑑 2 = 24,5
𝑃𝑑𝑑 = 23

1 + 𝑖 − 𝑑 1,06 − 0,7
𝑞= = = 0,60 ⟹ 1 − 𝑞 = 0,40
𝑢−𝑑 1,3 − 0,7

Knot I.

𝑞 ∗ 𝑃𝑈𝑈 + (1 − 𝑞) ∗ 𝑃𝑈𝑑 0,60 ∗ 0 + 0,40 ∗ 2

𝑃𝑈 = = = 0,7547
1 + 𝑟𝑓 1,06

Knot II.

𝑞 ∗ 𝑃𝑢𝑑 + (1 − 𝑞) ∗ 𝑃𝑑𝑑 0,60 ∗ 2 + 0,40 ∗ 23

𝑃𝑑 = = = 9,8113
1 + 𝑟𝑓 1,06

Knot III.

𝑞 ∗ 𝑃𝑢 + (1 − 𝑞) ∗ 𝑃𝑑 0,6 ∗ 0,7547 + 0,4 ∗ 9,8113

𝑃0 = = = 4,1296
1 + 𝑟𝑓 1,06

We can also directly calculate the price as:

𝑞 2 𝑃𝑢𝑢 + 2𝑞(1 − 𝑞)𝑃𝑢𝑑 + (1 − 𝑞)2 𝑃𝑑𝑑 0,62 ∗ 0 + 2 ∗ 0,6 ∗ 0,4 ∗ 2 + 0,42 ∗ 23

𝑃0 = = = 4,1296
1 + 𝑟𝑓 1,06
 Timo Reichmann: Tutorial 3 FoF Solution

4. Binomial Trees: Valuing European Options

Assume the same setup as in exercise 3. Now calculate the value of an American Put Option, using risk
neutral valuation.

𝑆𝑢𝑢 = 𝑆0 𝑢2 = 84,5
𝑆𝑢 = 𝑆0 𝑢 = 65 𝑃𝑈𝑈 = 0
𝑷𝑼 = 𝟎, 𝟕𝟓𝟒𝟕 I.

𝑆0 = 50 𝑆𝑢𝑑 = 𝑆0 𝑢𝑑 = 45,5
III.
𝑷𝟎 = 𝟓, 𝟏𝟒𝟒𝟐 𝑃𝑢𝑑 = 2

𝑆𝑑 = 𝑆0 𝑑 = 35 II.
𝑷𝒅 = 𝟏𝟐, 𝟓𝟎
𝑆𝑑𝑑 = 𝑆0 𝑑 2 = 24,5
𝑃𝑑𝑑 = 23

1 + 𝑖 − 𝑑 1,06 − 0,7
𝑞= = = 0,60 ⟹ 1 − 𝑞 = 0,40
𝑢−𝑑 1,3 − 0,7

Note that 𝑃𝑎 ≥ 𝑃𝑒

𝑃𝑈𝑎 = 𝑃𝑈𝑒 = 0,7547, note that the exercise value of the American Put Option is zero ,see
max(47,5 − 65 ; 0) =0 . Thus, the investor does not exercise the option!

𝑃𝑈 = max(47,5 − 35 ; 0) = 12,50 > 𝑃𝑈𝑒 = 9,8113 ⇒ 𝒆𝒙𝒆𝒓𝒄𝒊𝒔𝒆 𝑷𝒖𝒕 𝑶𝒑𝒕𝒊𝒐𝒏!

0,6 ∗ 0,7547 + 0,4 ∗ 12,50

𝑃0 = = 5,1442
1,06

Please note: In the caculations above 𝑷𝒂 denotes the price for an American put option, whereas 𝑷𝒆 is the
price of a European put option. Prices for the European options, e.g. 𝑷𝒆𝑼 are calculated in exercise 3.
 Timo Reichmann: Tutorial 3 FoF Solution

5. Black-Scholes Formula

The current stock price is 𝑆 = 50€. Its volatility (=annualized standard deviation) is 𝛿 = 20% 𝑝. 𝑎. and
the interest rate on risk-free investments is 𝑖 = 5% 𝑝. 𝑎. (continuously compounded). What is the price
of a call with strike price of 55 Euros and maturity in 9 months from now?

The price of an European Call Option or an American Call Option on a non-dividend paying underlying in the
Black-Scholes Modell is calculated as follows:

𝐶𝑡 = 𝑆𝑡 ∗ 𝑁(𝑑1 ) + 𝐾 ∗ 𝑒 −𝑖∗(𝑇−𝑡) ∗ 𝑁(𝑑2 )

Where 𝑁(𝑑1 ) is interpreted as the units of stocks bought and 𝐾 ∗ 𝑒 −𝑖∗(𝑇−𝑡) ∗ 𝑁(𝑑2 ) is the loan.

First, we need to calculate 𝑑1 , 𝑑2 and then insert them into the above pricing equation:

𝑆 1 50 1 9
ln ( 𝐾𝑡 ) + (𝑖 + 2 ∗ 𝜎 2 ) ∗ (𝑇 − 𝑡) ln ( ) + (0,05 + 2 ∗ 0,202 ) ∗ 12
𝑑1 = = 55 = −0,2472
𝜎√𝑇 − 𝑡 9
0,20 ∗ √12

9
𝑑2 = 𝑑1 − 𝜎 ∗ √𝑇 − 𝑡 = −0,2472 − 0,20 ∗ √ = −0,4203
12

9
𝐶0 = 50 ∗ 𝑁(−0,2472) + 55 ∗ 𝑒 −0,05∗12 ∗ 𝑁(−0,4203)
≈ 50 ∗ (1 − 𝑁(0,25)) − 52,9757 ∗ (1 − 𝑁(0,42))
= 50 ∗ (1 − 0,5987) − 52,9757 ∗ (1 − 0,6628) = 2,2016
 Timo Reichmann: Tutorial 3 FoF Solution

6. Option Strategies

We will evaluate and draw different option strategies together. More information will be given in the
tutorial.

6.1 Bull-Call Spread (see lecture slides 31 – 32)

Suppose your option portfolio consists of a long call with strike price 𝐾1 = €45 (price is €7,538) and a
short call with strike 𝐾2 = €55 (Price is €2,2016). Both options have the same maturity. Draw the
payoff-profile and the P&L of this strategy! What is the idea behind the strategy? Furthermore, make
some statements about the performance of the strategy (maximum loss, Break-Even, etc.).

Payoff and Profit & Loss Functions of a Bull-Call Spread Option Strategy:

One combines the known graphs of the individual options the strategy consists of and yields:

𝑃𝑎𝑦𝑜𝑓𝑓 / 𝑃𝑟𝑜𝑓𝑖𝑡 & 𝐿𝑜𝑠𝑠

Payoff
𝐾2 − 𝐾1 = 10

P&L

𝐾1 = 45 𝐾2 = 55

0 𝑆𝑇

−𝐶1 + 𝐶2 = −5,3364 𝐵𝑟𝑒𝑎𝑘 − 𝐸𝑣𝑒𝑛 − 𝑃𝑜𝑖𝑛𝑡 = 50,3364

The price of the strategy is 5,3364.

One can see that the Break-Even is at: 45 + 5,3364 = 50,3364 and that Maximum Loss is 5,3364.
The idea behind the strategy is a bet on moderately increasing prices. One expects the stock price to
increase and thus buys a call with strike of 45. Further it is assumed that the price is not increasing much
over 55 (give up upward potential and earn premium by selling a short call with strike 55).
Maximum profit is 10 - 5,3364= 4,6636.
 Timo Reichmann: Tutorial 3 FoF Solution

6.2 Long Straddle

Suppose your option portfolio consists of a long put with strike price 𝐾1 = €50 (price is 𝑃 = €2,55)
and a long call with strike 𝐾2 = €50 (Price is 𝐶 = €4,39). Both options have the same maturity. Draw
the payoff-profile and the P&L of this strategy! What is the idea behind the strategy? Furthermore, make
some statements about the performance of the strategy (maximum loss, Break-Even, etc.).

Payoff and Profit Functions of a Strangle Long Option Strategy

𝑃𝑎𝑦𝑜𝑓𝑓 / 𝑃𝑟𝑜𝑓𝑖𝑡 & 𝐿𝑜𝑠𝑠

Payoff
𝐾1 = 50
𝐾1 − 𝑃 − 𝐶 Profit & Loss
= 43,06

𝐾1 = 𝐾2 = 50

0 𝑆𝑇

𝐵𝑟𝑒𝑎𝑘 − 𝐸𝑣𝑒𝑛 𝐵𝑟𝑒𝑎𝑘 − 𝐸𝑣𝑒𝑛 − 𝑃𝑜𝑖𝑛𝑡2 = 56,94

− 𝑃𝑜𝑖𝑛𝑡1 = 43,06
−𝑃 − 𝐶
= −6,94

The price of the strategy is 6.94.

Now, the idea behind the strategy is, that the investor expects large price movements but it is not clear in
which direction exactly. Thus, the strategy is a bet on heavy price movements in general of the underlying
stock. It would lead to a loss from a P&L perspective if only very small price movements would occur and
we would fall under the respective break-even-points.

Maximum loss: 6.94 Euro

Maximum profit: Infinity
 Timo Reichmann: Tutorial 3 FoF Solution

6.3 Long Strangle

Suppose your option portfolio consists of a long put with strike price 𝐾𝑃 = €45 (price is 𝑃 = €0,93)
and a long call with strike 𝐾𝐶 = €55 (Price is 𝐶 = €2,2016). Both options have the same maturity.
Draw the payoff-profile and the P&L of this strategy! What is the idea behind the strategy? Furthermore,
make some statements about the performance of the strategy (maximum loss, Break-Even, etc.).

Payoff and Profit Functions of a Strangle Long Option Strategy

𝑃𝑎𝑦𝑜𝑓𝑓 / 𝑃𝑟𝑜𝑓𝑖𝑡

𝐾𝑃 Payoff
= 45
Profit & Loss

𝐾𝑃 − 𝑃 − 𝐶
= 41,8684

𝐾𝑃 = 45 𝐾𝐶 = 55

0 𝑆𝑇

𝐵𝑟𝑒𝑎𝑘 − 𝐸𝑣𝑒𝑛 𝐵𝑟𝑒𝑎𝑘 − 𝐸𝑣𝑒𝑛 − 𝑃𝑜𝑖𝑛𝑡2 = 58,1316

− 𝑃𝑜𝑖𝑛𝑡1
−𝑃 − 𝐶
= 41,8684
= −3,1316

The price of the strategy is 3.13. Overall this strategy is cheaper than the strategy in Exercise 6.2 which
comes from the different strike prices of the options. The range where you lose money is bigger (the
difference between the two break even points). However, the overall idea behind the strategy is the
same, the expected positive or negative stock price movements are bigger.

Maximum loss: 3.13 Euro

Maximum profit: Infinity