Cornell University

AEM 420, Wang, Fall 04

HW3, Options
*Due Date: 11/18/04

Instructions: Show all relevant calculations. No partial credit will be awarded without legible accompanying
calculations. When using the Black-Scholes-Merton.xls spreadsheet, relevant calculations will be showing
how you determined input parameters, in addition to what the question requests. The spreadsheet can be
found under the Course Tools folder on Blackboard.

*You may hand in questions 1-4 in class on 11/11/04. If you do so, you may come to office hours to discuss
the solutions. All questions are due in class on 11/18/04.

1. Binomial Model and Arrow Securities

Assume that the future possible paths for the dollar value of a share of XYZ Corp are accurately described by
the following binomial model over the next 2 years. The risk-free rate is 5% per year. “t” corresponds to the
beginning of year.

70 State A
90
110 State B
100
90 State C
115
140 State D

t=0 t=1 t=2

(a) What is the price of a 2-year European call option to buy 1000 shares of XYZ for $100 per share?
Use the replication method, and show all work.

(b) What is the price of a 2-year European call option to buy 1000 shares of XYZ for $100 per share?
Use the risk-neutral probability method, and show all work.

(c) Assume Arrow Securities for end-of-year-2 payoffs are freely traded in the market. Recall that
Arrow Securities are securities, which pay off $1 in any given state. What are the prices of each
Arrow Security? (label them A, B, C, and D, to correspond with the figure above)

(d) What combination of Arrow Securities would be equivalent to the call option described in (a)?
Using the Arrow Securities, what is the price of the call option?

(e) Using any method you choose, price Squiggle AAA. Squiggle AAA pays $1,000,000 in State A,
$500,000 in State B, $100,000 in State C, and $2,000,000 in State D.

(f) Using any method you choose, determine the risk characteristics of Squiggle AAA (i.e. what is
the exposure to stock and riskfree asset) at t=0 and all possible points at t=1?
2. Option Greeks and Hedging
You work in the risk management division of Traders R Us (TRU), a brokerage company primarily serving
day traders. When the tech market volatility is high, TRU receives many trades orders and is highly
profitable; but when market volatility is low TRU loses money. Your internal financial auditors approximate
the relation between incremental annual profitability and tech market volatility at $1 million per 1% increase
in volatility, with zero profitability at 20% volatility. You recall the 1460 course from your days at HBS and
realize there must be a way to hedge your profits, and your boss authorizes you to try a hedge for the next
year.

QQQ is an Exchange traded fund that essentially replicates the Nasdaq100 returns. (For more information,
enter symbol QQQ from http://finance.yahoo.com or visit NASDAQ’s website at
http://www.nasdaq.com/Structuredeq/nasdaq_etf_family.stm)

The current price of a share of QQQ is $38.57. Dividends and expenses should be ignored for this analysis.
The riskfree rate is 2% per annum, annually compounded. The following are European options on QQQ are
available today, 10/21/04:

Type Put (A) Call (B) Call (C)

Strike 36 38 40
Implied Volatility 25.3% 21.6% 21.2%
Expiration 10/21/05 10/21/05 10/21/05
Price
Delta
Gamma
Vega
Position

(a) Using the BSM.xls spreadsheet (available on the course website), calculate the price, delta,
gamma, and vega given by Black-Scholes for each option above.

(b) Find a delta-neutral and gamma-neutral portfolio (i.e. the portfolio has a delta of zero and a
gamma of zero) with an initial cost of $1. What are the positions required of each option A, B,
and C to create this portfolio? What is the Vega of this portfolio?

(c) What level of Vega exposure would you recommend to implement a complete vega hedge?
Why? How would you achieve this exposure (equity option contracts are per 100 shares of the
underlying).

(d) Assume that the price of QQQ instantly increases to $39.57 per share. Recalculate the price,
delta, gamma, and vega for each option above. Calculate the realized return on a long position
for each option and for the underlying QQQ share from before to after the instantaneous increase
in price.
3. Implied Volatility
EBAY stock traded in the market at $73.56 at the close of trade on 2/10/03. The attached pages show
selected option chains at that time. Use these tables for the following questions. Hint: use the BSM
spreadsheet provided on the course website. Assume a continuously compounded riskfree rate of 2% per
year.

(a) Focus on the “at-the-money” options (for each maturity, with strike price as close as possible to the
current stock price). Plot the implied volatility term structure directly from market prices; i.e. σ(T1),
σ(T2), … σ(TN). In other words, plot a graph with implied volatility on the y-axis and time to expiration on
the x-axis.

(b) Focus on the Feb 03 options (which expire on February 21, 2003). Plot the implied volatility for each
strike price listed.

4. Extracting Information from the Market

Stock A and Stock B are actively traded in the market, as are their options. Neither stock pays dividends.
The current market prices are $100 for A and $80 for B. The risk-free rate is 2% continuously compounded.

(a) The price of a 1-year European call option on Stock A with strike $90 is $13.37. The price of a 1-year
European call option on Stock B with strike $85 is $6.57. What is implied volatility for Stocks A over the
next year? For Stock B?

There is an active market for index options. The index is composed of 1 share of A and one share of B, and
the index level is the sum of the component prices (i.e. the current index level is $180). There exists a call
option to buy 1 unit of the index for $175 at one year.

(b) If market price of the basket option is $16.54, what is the implied correlation of returns between Stocks A
and B?

(c) If market price of the basket option is $14.54, what is the implied correlation of returns between Stocks A
and B?

(d) If market price of the basket option is $18.26, what is the implied correlation of returns between Stocks A
and B?

(e) How might we use this information about implied volatility and correlations?
5. Risky Debt Analysis: Binomial Model
ZYX is a holding company whose only assets are 1,000,000 shares of XYZ Corp. Assume that the future
possible paths for the dollar value of a share of XYZ Corp are accurately described by the following
binomial model over the next 2 years. The risk-free rate is 5% per year. “t” corresponds to the beginning of
the year.

70
90
110
100
90
115
140

t=0 t=1 t=2

ZYX has outstanding 1-year and 2-year zero-coupon debt, with face value $30 million each in Junior 1-year
debt, Senior 1-year debt, Junior 2-year debt, and Senior 2-year debt. ZYX is prohibited by covenant from
either issuing any more debt or making any cash distributions to its shareholders until all outstanding debt is
paid. Thus the firm will liquidate some of its assets to make payments on the debt.

A default occurs at the time of a failed promised payment for any security. In the event of default, all firm
debt becomes immediately due in the amount of the present value of the face value (discounted at the risk-
free rate). In the event of default, the senior debt will have absolute first priority for the entire present value
before junior debt receives anything. Do pricing and analysis according to the Merton Model.

(a) What is the current dollar value and yield to maturity (YTM) of each debt issue and of equity?

(b) What are the possible t=1 YTM of each debt issue?

(c) Rank the debt issues in terms of “economic seniority”.[i.e., rank the four bond issues from
largest to smallest in terms of the percentage of the replicating-portfolio value in the risk-free
asset].
6. Risky Debt Analysis: Black-Scholes-Merton Model
ABCD is a firm with $100 million in assets (market value). The estimated return standard deviation of
ABCD’s assets is 20% per year, and the risk-free rate is 5% per year. ABCD has outstanding debt, including:

1. $40 million face value of Senior 2-year, zero-coupon debt

2. $50 million face value of Junior 2-year, zero-coupon debt

In the event of default, the senior debt will have first priority to have its principal amounts paid before junior
debt receives anything. ABCD is prohibited by covenant from either issuing any more debt or making any
distributions to its shareholders until all outstanding debt is paid. Do pricing and analysis according to the
Merton Model.

(a) What is the current dollar value of the Senior debt? Is there a yield to maturity (YTM) for
Senior debt, and if so what is it?

(b) What is the current dollar value of the Junior debt? Is there a yield to maturity (YTM) for Junio
debt, and if so what is it?

(c) What is the current dollar value of the Equity? Is there a yield to maturity (YTM) for Equity,
and if so what is it?
Expires After: Fri 21-Feb-03 Options Center | Analyzer | Most Actives | Symbology | Calendar
Options: Feb-03 | Mar-03 | Apr-03 | Jul-03 | Jan-04 | Jan-05 | Jan-05 Highlighted options are in-the-money
Calls Strike
Puts
Last Open Price Last Open
Symbol Trade Chg Bid Ask Vol Int Symbol Trade Chg Bid Ask Vol Int
QXBBI.X 27.50 0.00 28.50 28.70 0 50 45.00 QXBNI.X 0.05 0.00 0.00 0.05 0 32
QXBBJ.X 23.40 0.00 23.50 23.70 0 51 50.00 QXBNJ.X 0.05 0.00 0.00 0.05 0 187
QXBBK.X 17.50 0.00 18.50 18.70 1 554 55.00 QXBNK.X 0.05 0.00 0.00 0.05 0 1,194
QXBBL.X 12.50 0.00 13.50 13.70 0 226 60.00 QXBNL.X 0.05 -0.05 0.00 0.10 40 3,637
QXBBM.X 7.80 0.00 8.60 8.90 0 865 65.00 QXBNM.X 0.20 -0.10 0.10 0.20 218 9,318
QXBBN.X 4.20 +0.70 4.10 4.30 514 5,065 70.00 QXBNN.X 0.60 -0.40 0.55 0.65 442 9,758
QXBBO.X 1.05 +0.35 0.95 1.10 375 15,938 75.00 QXBNO.X 2.50 -0.90 2.35 2.50 307 8,877
QXBBP.X 0.15 +0.05 0.10 0.20 168 12,599 80.00 QXBNP.X 6.50 -1.40 6.40 6.60 45 1,560
QXBBQ.X 0.05 0.00 0.00 0.10 0 8,202 85.00 QXBNQ.X 12.00 -0.80 11.30 11.50 50 359
QXBBR.X 0.05 0.00 0.00 0.10 0 241 90.00 QXBNR.X 17.50 0.00 16.30 16.60 0 553
QXBBS.X 0.00 0.00 0.00 0.10 0 0 95.00 QXBNS.X 22.60 0.00 21.30 21.60 0 23

Expires After: Fri 21-Mar-03 Options Center | Analyzer | Most Actives | Symbology | Calendar
Options: Feb-03 | Mar-03 | Apr-03 | Jul-03 | Jan-04 | Jan-05 | Jan-05 Highlighted options are in-the-money
Calls Strike
Puts
Last Open Price Last Open
Symbol Trade Chg Bid Ask Vol Int Symbol Trade Chg Bid Ask Vol Int
PYPCW.X 11.10 0.00 10.90 11.60 0 0 17.50 PYPOW.X 0.25 0.00 0.00 0.25 0 1
PYPCD.X 8.50 0.00 8.50 9.00 0 0 20.00 PYPOD.X 0.25 0.00 0.00 0.25 0 10
PYPCX.X 6.10 0.00 6.10 6.60 0 12 22.50 PYPOX.X 0.25 0.00 0.00 0.25 0 0
PYPCE.X 4.00 0.00 4.00 4.40 0 21 25.00 PYPOE.X 0.55 0.00 0.30 0.55 0 0
QXBCJ.X 22.70 0.00 23.60 23.80 0 55 50.00 QXBOJ.X 0.15 0.00 0.05 0.15 0 679
QXBCK.X 17.70 -0.10 18.70 19.00 1 50 55.00 QXBOK.X 0.30 -0.05 0.15 0.30 25 707
QXBCL.X 13.30 0.00 14.10 14.30 0 138 60.00 QXBOL.X 0.55 -0.20 0.50 0.65 31 1,925
N/A 0 N/A N/A N/A N/A N/A 65.00 QXBOM.X 1.25 -0.25 1.15 1.25 60 3,381
N/A 0 N/A N/A N/A N/A N/A 70.00 QXBON.X 2.50 -0.30 2.30 2.45 124 7,756
QXBCO.X 3.00 +0.55 2.95 3.10 702 3,164 75.00 QXBOO.X 4.40 -0.80 4.30 4.50 144 4,352
N/A 0 N/A N/A N/A N/A N/A 80.00 QXBOP.X 7.90 -0.80 7.40 7.70 2 382
QXBCQ.X 0.25 -0.05 0.30 0.45 250 4,811 85.00 N/A 0 N/A N/A N/A N/A N/A
QXBCR.X 0.15 0.00 0.10 0.15 0 679 90.00 QXBOR.X 17.60 0.00 16.30 16.60 0 30
QXBCS.X 0.05 0.00 0.05 0.15 0 20 95.00 QXBOS.X 22.60 0.00 21.30 21.60 0 50
Expires After: Thu 17-Apr-03 Options Center | Analyzer | Most Actives | Symbology | Calendar
Options: Feb-03 | Mar-03 | Apr-03 | Jul-03 | Jan-04 | Jan-05 | Jan-05 Highlighted options are in-the-money
Calls Strike
Puts
Last Open Price Last Open
Symbol Trade Chg Bid Ask Vol Int Symbol Trade Chg Bid Ask Vol Int
QXBDF.X 42.50 0.00 43.50 43.70 0 923 30.00 QXBPF.X 0.05 0.00 0.00 0.05 0 1,308
QXBDG.X 37.60 0.00 38.50 38.70 0 7 35.00 QXBPG.X 0.10 0.00 0.00 0.10 0 719
QXBDH.X 32.60 0.00 33.60 33.80 0 212 40.00 QXBPH.X 0.10 0.00 0.00 0.15 0 852
QXBDI.X 27.50 0.00 28.70 29.00 0 248 45.00 QXBPI.X 0.25 0.00 0.15 0.25 0 5,484
QXBDJ.X 22.90 0.00 23.90 24.20 0 133 50.00 QXBPJ.X 0.60 0.00 0.40 0.45 0 2,219
QXBDK.X 18.60 0.00 19.30 19.60 0 2,322 55.00 QXBPK.X 0.90 -0.10 0.75 0.85 50 3,520
QXBDL.X 14.30 0.00 15.00 15.20 0 3,301 60.00 QXBPL.X 1.50 -0.25 1.40 1.50 56 2,749
QXBDM.X 10.40 0.00 11.00 11.20 0 7,154 65.00 QXBPM.X 2.40 -0.45 2.35 2.50 25 9,430
QXBDN.X 7.00 +0.10 7.50 7.70 350 11,086 70.00 QXBPN.X 3.90 -0.60 3.80 4.00 134 9,618
QXBDO.X 4.50 +0.30 4.70 4.80 95 12,508 75.00 QXBPO.X 6.10 -0.80 6.00 6.20 244 2,088
QXBDP.X 2.60 +0.35 2.55 2.75 99 8,569 80.00 QXBPP.X 9.70 -0.10 8.80 9.10 8 1,014
QXBDQ.X 1.05 -0.10 1.25 1.40 44 5,840 85.00 QXBPQ.X 13.50 0.00 12.50 12.70 0 307
QXBDR.X 0.50 0.00 0.50 0.65 19 283 90.00 QXBPR.X 17.70 +0.70 16.80 17.00 1 31

Expires After: Fri 18-Jul-03 Options Center | Analyzer | Most Actives | Symbology | Calendar
Options: Feb-03 | Mar-03 | Apr-03 | Jul-03 | Jan-04 | Jan-05 | Jan-05 Highlighted options are in-the-money
Calls Strike
Puts
Last Open Price Last Open
Symbol Trade Chg Bid Ask Vol Int Symbol Trade Chg Bid Ask Vol Int
QXBGH.X 33.10 0.00 34.00 34.30 0 74 40.00 QXBSH.X 0.45 0.00 0.40 0.50 0 580
QXBGI.X 28.50 0.00 29.30 29.70 0 35 45.00 QXBSI.X 0.85 0.00 0.75 0.85 0 262
QXBGJ.X 23.80 -0.40 24.90 25.30 10 4 50.00 QXBSJ.X 1.45 0.00 1.25 1.40 0 852
QXBGK.X 20.00 0.00 20.70 21.10 0 77 55.00 QXBSK.X 2.35 +0.10 2.05 2.20 2 639
QXBGL.X 16.20 0.00 16.80 17.10 0 121 60.00 QXBSL.X 3.50 0.00 3.10 3.20 0 2,475
QXBGM.X 13.30 +0.90 13.30 13.50 52 1,250 65.00 QXBSM.X 4.80 -0.10 4.40 4.70 44 1,406
QXBGN.X 9.60 0.00 10.10 10.30 0 2,922 70.00 QXBSN.X 6.80 +0.10 6.20 6.40 2 4,048
QXBGO.X 7.30 +0.70 7.30 7.50 31 5,492 75.00 QXBSO.X 9.00 -0.20 8.50 8.70 42 3,287
QXBGP.X 4.50 -0.50 5.10 5.30 20 2,124 80.00 QXBSP.X 11.90 0.00 11.20 11.50 0 225
QXBGQ.X 3.50 +0.40 3.40 3.60 100 3,084 85.00 QXBSQ.X 15.20 0.00 14.50 14.70 0 134
QXBGR.X 2.00 +0.05 2.15 2.30 1 3,539 90.00 QXBSR.X 18.50 0.00 18.20 18.40 0 242
Expires After: Fri 16-Jan-04 Options Center | Analyzer | Most Actives | Symbology | Calendar
Options: Feb-03 | Mar-03 | Apr-03 | Jul-03 | Jan-04 | Jan-05 | Jan-05 Highlighted options are in-the-money
Calls Strike
Puts
Last Open Price Last Open
Symbol Trade Chg Bid Ask Vol Int Symbol Trade Chg Bid Ask Vol Int
KAFAD.X 53.60 0.00 53.60 53.90 0 224 20.00 KAFMD.X 0.15 0.00 0.10 0.20 0 1,047
KAFAE.X 47.90 0.00 48.90 49.10 0 116 25.00 KAFME.X 0.35 0.00 0.20 0.35 0 1,652
KAFAF.X 43.30 0.00 44.20 44.50 0 2,092 30.00 KAFMF.X 0.55 0.00 0.50 0.65 0 2,321
KAFAG.X 38.80 0.00 39.70 40.00 0 696 35.00 KAFMG.X 1.10 0.00 1.00 1.10 0 1,466
KAFAH.X 34.50 0.00 35.30 35.70 0 2,372 40.00 KAFMH.X 1.75 0.00 1.55 1.75 0 4,131
KAFAJ.X 26.50 0.00 27.20 27.60 0 3,445 50.00 KAFMJ.X 3.70 0.00 3.40 3.50 0 6,620
KAFAL.X 20.10 +0.70 20.00 20.40 5 4,200 60.00 KAFML.X 6.50 0.00 6.10 6.30 0 15,125
KAFAN.X 13.40 0.00 14.10 14.30 0 15,133 70.00 KAFMN.X 10.10 -0.30 9.90 10.10 40 5,134
KAFAP.X 8.70 0.00 9.20 9.50 0 11,936 80.00 KAFMP.X 15.70 0.00 14.90 15.20 0 2,889
KAFAR.X 5.30 0.00 5.60 5.90 0 9,822 90.00 KAFMR.X 22.10 0.00 21.30 21.60 0 104
KAFAT.X 3.20 0.00 3.20 3.50 0 1,325 100.00 KAFMT.X 30.20 0.00 28.90 29.20 0 301

Expires After: Fri 21-Jan-05 Options Center | Analyzer | Most Actives | Symbology | Calendar
Options: Feb-03 | Mar-03 | Apr-03 | Jul-03 | Jan-04 | Jan-05 | Jan-05 Highlighted options are in-the-money
Calls Strike
Puts
Last Open Price Last Open
Symbol Trade Chg Bid Ask Vol Int Symbol Trade Chg Bid Ask Vol Int
XNEAD.X 53.70 0.00 54.40 54.80 0 657 20.00 XNEMD.X 0.75 +0.05 0.55 0.75 1 2,683
XNEAE.X 49.40 0.00 50.10 50.60 0 291 25.00 XNEME.X 1.30 +0.05 1.15 1.30 10 1,160
XNEAF.X 45.40 0.00 46.00 46.50 0 185 30.00 XNEMF.X 2.00 0.00 1.95 2.10 0 768
XNEAG.X 41.10 -0.50 42.20 42.60 1 121 35.00 XNEMG.X 3.00 0.00 2.80 3.10 0 353
XNEAH.X 37.90 0.00 38.50 38.90 0 889 40.00 XNEMH.X 4.10 0.00 4.00 4.20 0 736
XNEAJ.X 31.10 0.00 31.70 32.10 0 520 50.00 XNEMJ.X 7.10 0.00 6.90 7.10 0 6,493
XNEAL.X 25.10 0.00 25.60 26.10 0 1,315 60.00 XNEML.X 10.80 0.00 10.50 10.70 0 2,254
XNEAN.X 19.80 0.00 20.40 20.80 0 3,578 70.00 XNEMN.X 15.50 0.00 14.90 15.20 0 3,830
XNEAP.X 15.00 -0.40 15.80 16.10 10 15,078 80.00 XNEMP.X 20.90 +0.10 20.10 20.40 2 7,653
XNEAR.X 11.70 0.00 12.10 12.50 0 810 90.00 XNEMR.X 27.00 0.00 26.20 26.50 0 1,286
XNEAT.X 9.10 +0.30 9.10 9.40 75 1,813 100.00 XNEMT.X 33.70 0.00 33.00 33.40 0 463