SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE 1

Sample Examination Paper

Edinburgh Business School
Finance

C39SN Financial Derivatives

Tutorial 2:
Option Pricing - Answers

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE 2

Tutorial 1: Optin Payoffs and Strategies

Course: Financial Derivatives

Course Code: C39SN
Author: Boulis Ibrahim

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE

Answer the following questions:

1. Draw the payoff and profit graphs of selling short (shorting or writing) a call
option on a share. Identify the range of values of the share price that would profit
the option seller. Repeat this exercise for selling short a put option on a share.
Assume that both options have equal premia of 20 pence and exercise price of 70
pence.

2. Consider a European Call option on Marks and Spencer’s shares. Assume that the
spot price of the share is £5.60 and has a constant volatility of 5% (i.e., the
standard deviation, , is 5%). Assume further that the exercise price of the Call is
£5.50 and the option matures in 90 days. A Treasury Bill with 90 days to maturity
is priced so as to yield 3% (i.e., the risk-free rate of interest is 3%). Answer the
following (assume 360 days in a year).
a) Is the option currently in-, at- or out-of-the-money?
b) Would this option have a value?
c) What is the intrinsic value of this option?
d) Use the Black-Scholes formula to calculate a price for this option.
e) What is the time value of this option?
f) What possible reason(s) for this option to have a time value?
g) If this option is selling at £0.05 more than the ‘fair value’ calculated in part
d) suggest an arbitrage strategy to exploit this price imbalance.

3. Head-scratching question! Attempt answering this question before reading the

book!
What are the bounds on the price of a European Put option? Graph these bounds
(in a graph where the y axis represents ‘value’ and the x-axis represents price of
the underlying asset, S), and suggest where within these bounds would the price of
the option be (hint: think of what would happen to the price of a put option if the
share price declines to zero or increases to infinity).

4. If the price of a call option has just decreased does this mean that it is now a better
buy?

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

 SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE 4

Question 1
E=70 p
Premium = 20 p

Selling short a call option

Selling a call option means that the seller has an obligation to sell shares at 70 p per share if the buyer of the option wants to exercise it.

 If the market share price S=70, the option payoff

is 0. But the seller of the option has received a
premium of 20p when the contract was signed, so
his profit is 20p.
 If the market share price S<70, the buyer will not
exercise the option because he/she can buy the
shares in the market at a lower price. The option
payoff is 0. Seller’s profit is 20p.
 If the market share price S>70, the buyer will
exercise the option. The option payoff is E-S
Seller of Call = - Max (0,S – E)

Profit
Market stock Point on the Point on the
Exercise price Payoff =E-S (if option exercised) Premium (=payoff
price (S) graph graph
(E) +premium)
70 30 0 (option is not exercised) C 20 20 C’
70 50 0 (option is not exercised) B 20 20 B’
70 70 0 A 20 20 A’
70 90 -20 D 20 0 D’

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE 5

70 110 -40 F 20 -20 F’

Selling short a put option
Sell put option means that the seller has an obligation to buy shares at 70 p per share if the buyer of the option wants to exercise it.

 If the market share price S=70, the option payoff

is 0. But the seller of the option has received a
premium of 20p when the contract was signed, so
his profit is 20p.
 If the market share price S>70, the buyer will not
exercise the option because he/she can sell the
shares in the market at a higher price. The option
payoff is 0. Seller’s profit is 20p.
 If the market share price S<70, the buyer will
exercise the option. The option payoff is S-E. In
this case the profit will decrease by the amount of
the payoff.

Profit
Market stock Payoff =S-E (if option Point on the Point on the
Exercise price (E) Premium (=payoff
price (S) exercised) graph graph
+premium)
70 0 -70 C 20 -50 C’
70 50 -20 B 20 0 B’
70 70 0 A 20 20 A’
70 90 0 (option is not exercised) D 20 20 D’
70 110 0 (option is not exercised) F 20 20 F’

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE

Question 2
Call option: a right to the holder to buy stocks at exercise price E = £5.50.
S = £5.60
E = £5.50
σ = 5% (volatility)
r = 3%
t=90 days = 0.25 year

a) Definition: An in-the-money option would give the holder of the option a

positive cash flow if it were exercised immediately.

If the option is exercised immediately, the holder has a right to buy stocks at
5.50, whereas current market price is higher, 5.60. So, the holder of the option
will get a positive cash flow of 0.10 => the option is in-the-money. (positive
intrinsic value)

b) Yes, firstly, because it is in-the-money, secondly because it still has time to

maturity and volatility (so there’s a chance that the option will be in-the-
money in the future were it not in-the-money now).
(The value of an option is comprised of 3 parts: being in-the-money, having
volatility, and having time to maturity).
c) The intrinsic value of an option is defined as the maximum of zero and the
value the option would have if it were exercised immediately.

Intrinsic value = max[0, S-E]

S-E = 0.10, which is greater than zero => the intrinsic value of the option is
£0.10.

d) Price of the option. Apply the Black-Scholes formula: (ALWAYS IN EXAM)

C = S*N(d1) – E*e-rt *N(d2)
2
ln(S/E )+(r +σ /2)*t
d 1=
σ∗√ t
d2 = d1 - σ * √ t

2
ln(5 . 60/5.50 )+(0 . 03 +(0 . 05) /2)*0 . 25
d1= =1. 03324
0 . 05∗ √0 . 25 , approximately 1.03
Using the N(d) tables given (on Vision) we read N(1.03) = 0.8485

d2 = 1.03324 - 0.05* √ 0.25 = 1.00824, approximately 1.01

Using the N(d) tables given (on Vision) we read N(1.01) = 0.8438
Substituting these values into the Black-Scholes equation we get
C = £5.60*0.8485 - £5.50*e-(0.03)*(0.25) * 0.8438 = £0.1454 or 14.54 pence

S/E = 5.6/5.5 = 1.01818

rT = 0.0.3 x 90/360 = 0.0075 (e -0.03x0.25)

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE

SD square root of T = 0.05 square root 90/360 = 0.025

D1 = N(1.03) = 0.8485
D2 = N(1.01) = 0.8438

AT LEAST 4 DECIMAL PLACES PUT SYMBOL

e) Time value of call option = price of call option – intrinsic value of call option
Time value of call option = £0.1454 - £0.10 = £0.0454 or 4.54 pence

f) The option has time value because it still has time to maturity (if t=0, then d 1
→∞, d2 =d1→∞, N(d1) = N(d2) = 1,
C = S*N(d1) – E*e-rt *N(d2) = S - E. But S - E is the intrinsic value of the option.
Thus, in case t=0 price of the option equals the intrinsic value of the option =>
Time value of call option = C - intrinsic value of call option = (S-E) – (S-E) =
0).

g) Cactual = 0.1454 + 0.05 = £0.1954 (ALWAYS IN EXAM)

Since the actual price of the option in the market is greater than its theoretical
price calculated by the Black-Scholes, then the option is overpriced in the
market (this assumes no transaction costs and other frictions). Therefore, we
should sell the ‘expensive’ option, but to achieve riskless arbitrage profits one
needs to buy an equivalent strategy. The Black-Scholes gives us a description
of the equivalent strategy: C is equivalent to buying N(d1) of S and selling
N(d2) of a Treasury Bill with face value equal to E.

Accordingly, arbitrage action is:

1. Buy Strategy 1: Buy N(d1) of the Marks and Spencer’s share (priced at S =
£5.60 each) and sell N(d2) of a Treasury Bill with face value £5.50.
2. Sell (write) a 90-day call option. The option is worth £0.1954 (the premium).

Cash flow from arbitrage action:

Action Cash flow at Time = now
Receive premium: 0.1954 (= 0.1454 +
Sell a call option
0.05)

Buy 0.8485 shares at £5.60 each Pay: -5.60*0.8485 = -4.7516

Sell 0.8438 T-bills with face value Receive: (5.50*e-0.03*0.25)*0.8438 =
E=£5.50 (4.6062)
Profit/Loss £0.05

Receive immediate profit of £0.05 per each option sold and equivalent strategy
bought.
Profit is exactly 0.05 because we have chosen the volumes of shares and T-
bills so that the numbers in the table correspond to the numbers in the option
pricing formula:
C = £5.60*0.8485 - £5.50*e-(0.03)*(0.25) * 0.8438 = £0.1454
=> - £5.60*0.8485 = £0.1454 + £5.50*e-0.03*0.25 * 0.8438

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE

Because of arbitrage trading there will be selling pressure on the call option
and buying pressure on the equivalent strategy. Thus, the price of the option
will decrease, or the price of the equivalent strategy will increase, or both until
the option is fairly valued with respect to its equivalent strategy. When
equilibrium is restored we will reverse the trading strategy in order to close the
position (i.e., sell shares, buy a call option, and buy T-bills).

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE

Question 3
For more detailed explanation see Chapter 3 ‘Principles of Option Pricing of the textbook
by Chance and Brooks, or the Hull textbook, section “Upper and Lower Bounds for Option
Prices” in the chapter “Properties of Stock Options”.

If a put option is exercised at maturity, the payoff will be the intrinsic value at the time, i.e.,
the amount by which the exercise price exceeds the stock price (E-S). Keeping everything
else constant, put options therefore become more valuable as the stock price decreases and
less valuable as the stock price increases.

If the stock price approaches zero, the option price approaches its maximum value. At
maturity, European options cannot be worth more than the exercise price E. It follows that
at present (i.e., any time prior to maturity) it cannot be worth more than the present value of
E. Thus, the maximum possible price of a put option is PV(E) = E*e-rt.

As the stock price goes to infinity, the option price approaches its minimum value.
Explanation: if a stock price is very high, the holder of the option is not interested to
exercise the option because he/she can sell the stock in the stock market at a higher price.
The option, therefore, loses its value and the option price approaches zero. A put option
also cannot have a negative value because the worst that can happen to a put option is that it
expires worthless.

So, we can now draw the graph of the put option price as a function of the stock price.

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

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The price bounds of a put option:

 Since the maximum possible price of put option is P = PV(E) , PV(E) is the upper bound of the option price.

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES

SCHOOL OF SOCIAL SCIENCES – EDINBURGH BUSINESS SCHOOL – FINANCE

 The option price cannot be lower than P = PV(E)-S, otherwise arbitrage will be
possible.
 Since the option price cannot be negative, if PV(E)-S < 0 (which is the same as S >
PV(E) ) , the option price will be zero.

Question 4
The decrease in the call option price can be a result of a decrease in the share price (S), the
passage of time, an increase in interest rates or a decrease in the estimated volatility of the
share price. This does not necessarily mean that the option is cheaper than it should be, but
that its price has decreased (i.e., cheaper than it was before the decrease). A security
cheaper than it should be (i.e., cheaper than a benchmark price based on its fundamental
value) implies that it is a bargain to buy. This means that it is mispriced and that the market
is not pricing it efficiently. This implies inefficient markets (in that secrurity). However, a
security that has just decreased in price could be because the fundamentals underlying its
true value have weakened and the new lower price simply reflected the new lower true
value of that security. This is what we would expect from an efficient market that prices
securities properly.

As we do not have enough information to judge whether the decline in the security price
reflected new weaker fundamentals or a genuine mispricing we cannot make a clear cut
decision as to which is true. In efficient markets the former is most likely to be the case (i.e.,
a reflection of weaker fundamentals).

C39SN FINANCIAL DERIVATIVES- TUTORIAL-OPTION PAYOFFS AND STRATEGIES