CHAPTER 20: OPTIONS MARKETS: INTRODUCTION

CHAPTER 20: OPTIONS MARKETS: INTRODUCTION

PROBLEM SETS

1. Options provide numerous opportunities to modify the risk profile of a portfolio.

The simplest example of an option strategy that increases risk is investing in an ‘all
options’ portfolio of at the money options (as illustrated in the text). The leverage
provided by options makes this strategy very risky, and potentially very profitable.
An example of a risk-reducing options strategy is a protective put strategy. Here,
the investor buys a put on an existing stock or portfolio, with exercise price of the
put near or somewhat less than the market value of the underlying asset. This
strategy protects the value of the portfolio because the minimum value of the stock-
plus-put strategy is the exercise price of the put.

2. Buying a put option on an existing portfolio provides portfolio insurance, which is

protection against a decline in the value of the portfolio. In the event of a decline in
value, the minimum value of the put-plus-stock strategy is the exercise price of the
put. As with any insurance purchased to protect the value of an asset, the trade-off
an investor faces is the cost of the put versus the protection against a decline in
value. The cost of the protection is the cost of acquiring the protective put, which
reduces the profit that results should the portfolio increase in value.

3. An investor who writes a call on an existing portfolio takes a covered call position.
If, at expiration, the value of the portfolio exceeds the exercise price of the call, the
writer of the covered call can expect the call to be exercised, so that the writer of
the call must sell the portfolio at the exercise price. Alternatively, if the value of the
portfolio is less than the exercise price, the writer of the call keeps both the
portfolio and the premium paid by the buyer of the call. The trade-off for the writer
of the covered call is the premium income received versus forfeit of any possible
capital appreciation above the exercise price of the call.

4. An option is out of the money when exercise of the option would be unprofitable.
A call option is out of the money when the market price of the underlying stock is
less than the exercise price of the option. If the stock price is substantially less than
the exercise price, then the likelihood that the option will be exercised is low, and
fluctuations in the market price of the stock have relatively little impact on the
value of the option. This sensitivity of the option price to changes in the price of
the stock is called the option’s delta, which is discussed in detail in Chapter 21. For
options that are far out of the money, delta is close to zero. Consequently, there is
generally little to be gained or lost by buying or writing a call that is far out of the
money. (A similar result applies to a put option that is far out of the money, with
stock price substantially greater than exercise price.)

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A call is in the money when the market price of the stock is greater than the
exercise price of the option. If stock price is substantially greater than exercise
price, then the price of the option approaches the order of magnitude of the price of
the stock. Also, since such an option is very likely to be exercised, the sensitivity of
the option price to changes in stock price approaches one, indicating that a $1
increase in the price of the stock results in a $1 increase in the price of the option.
Under these circumstances, the buyer of an option loses the benefit of the leverage
provided by options that are near the money. Consequently, there is little interest in
options that are far in the money.

5.
Cost Payoff Profit
a. Call option, X = $145.00 $5.18 $5.00 -$0.18
b. $100.00¤$$100.00¤¤$$
Put option, X = $145.00 0.48 0.00 -0.48
c. Call option, X = $150.00 1.85 0.00 -1.85
d. Put option, X = $150.00 1.81 0.00 -1.81
e. Call option, X = $155.00 0.79 0.00 -0.79
f. Put option, X = $155.00 5.95 5.00 -0.95

6. In terms of dollar returns, based on a $10,000 investment:

Price of Stock 6 Months from Now
Stock Price $ 80 $ 100 $ 110 $ 120
All stocks (100 shares) 8,000 10,000 11,000 12,000
All options (1,000 options) 0 0 10,000 20,000
Bills + 100 options 9,360 9,360 10,360 11,360
In terms of rate of return, based on a $10,000 investment:
Price of Stock 6 Months from Now
Stock Price $80 $100 $110 $120
All stocks (100 shares) -20% 0% 10% 20%
All options (1,000 options) -100 -100 0 100
Bills + 100 options -6.4 -6.4 3.6 13.6

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Rate of return (%)

100
All options
All stocks
Bills plus options
100
0
110 ST
– 6.4

–100

7. a. From put-call parity:

X 100
P  C  S0   10  100   $7.65
(1  rf )T
1.10.25

b. Purchase a straddle, i.e., both a put and a call on the stock. The total cost of the
straddle is $10 + $7.65 = $17.65

8. a. From put-call parity:

X 50
C  P  S0   4  50   $5.18
(1  rf )T
1.10.25
b. Sell a straddle, i.e., sell a call and a put, to realize premium income of
$5.18 + $4 = $9.18
If the stock ends up at $50, both of the options will be worthless and your
profit will be $9.18. This is your maximum possible profit since, at any
other stock price, you will have to pay off on either the call or the put. The
stock price can move by $9.18 in either direction before your profits
become negative.

c. Buy the call, sell (write) the put, lend $50/(1.10) 1/4

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The payoff is as follows:

Position Immediate CF CF in 3 months
ST ≤ X ST > X
Call (long) C = 5.18 0 S T – 50
Put (short) –P = 4.00 – (50 – S T) 0
50
Lending position  48.82 50 50
1.101 / 4
C–P+
Total 50 ST ST
 50.00
1.101 / 4
By the put-call parity theorem, the initial outlay equals the stock price:
S0 = $50
In either scenario, you end up with the same payoff as you would if you
bought the stock itself.

9. a. i. A long straddle produces gains if prices move up or down and limited losses
if prices do not move. A short straddle produces significant losses if prices move
significantly up or down. A bullish spread produces limited gains if prices move
up.

b. i. Long put positions gain when stock prices fall and produce very limited
losses if prices instead rise. Short calls also gain when stock prices fall but create
losses if prices instead rise. The other two positions will not protect the portfolio
should prices fall.

10. Note that the price of the put equals the revenue from writing the call, net initial
cash outlays = $38.00
Position ST < 35 35  ST  40 40 < ST
Buy stock ST ST
X2X2XX 2X2 ST
Write call ($40) 0 0 40 - ST
Buy put ($35) 35- ST 0 0
Total $35 ST $40

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Profit

$2

$35 $40
-$3

11. Answers may vary. For $5,000 initial outlay, buy 5,000 puts, write 5,000 calls:

Position ST = $30 ST = $40 ST =$50

Stock portfolio $150,000 X2X2XX2 X2

$200,000 $250,000
Write call(X=$45) 0 0 -$25,000
Buy put (X=$35) $25,000 0 0
Initial outlay -$5,000 -$5,000 -$5,000
Portfolio value $170,000 $195,000 $220,000

Compare this to just holding the portfolio:

Position ST = $30 ST = $40 ST =$50

Stock portfolio $150,000 X2X2XX2 X2

$200,000 $250,000
Portfolio value $150,000 $200,000 $250,000

12. a.
Outcome ST ≤ X ST > X
Stock ST + D ST + D
Put X – ST 0
Total X+D ST + D

b.
Outcome ST ≤ X ST > X
Call 0 ST – X
Zeros X+D X+D
Total X+D ST + D
The total payoffs for the two strategies are equal regardless of whether S T
exceeds X.

c. The cost of establishing the stock-plus-put portfolio is: S0 + P

The cost of establishing the call-plus-zero portfolio is: C + PV(X + D)

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Therefore:
S0 + P = C + PV(X + D)
This result is identical to equation 20.2.

13. a.
Position S T < X1 X 1  S T  X2 X 2 < S T  X3 X3 < S T
Long call (X1) 0 S T – X1 S T – X1 S T – X1
Short 2 calls (X2) 0 0 –2(S T – X2) –2(S T – X2)
Long call (X3) 0 0 0 S T – X3
Total 0 S T – X1 2X2 – X1 – S T (X2 –X1) – (X3 –X2) = 0

Payoff

X2 – X 1

ST
X1 X2 X3

b.
Position S T < X1 X 1  S T  X2 X2 < S T
Buy call (X2) 0 X2X2XX
0 2X2 S T – X2
Buy put (X1) X1 – S T 0 0
Total X1 – S T 0 S T – X2

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Payoff

X1

ST
X1 X2

14.
Position S T < X1 X 1  S T  X2 X2 < S T
Buy call (X2) 0 XX02 S T – X2
Sell call (X1) 0 –(S T – X1) –(S T – X1)
Total 0 X1 – S T X1 – X2

Payoff

0
ST
X1 X2

Payoff
–(X2 – X1)

15. a. By writing covered call options, Jones receives premium income of $30,000.
If, in January, the price of the stock is less than or equal to $45, then Jones
will have his stock plus the premium income. But the most he can have at that
time is ($450,000 + $30,000) because the stock will be called away from him
if the stock price exceeds $45. (We are ignoring here any interest earned over
this short period of time on the premium income received from writing the
option.) The payoff structure is
Stock price Portfolio value
less than $45 10,000 times stock price + $30,000
greater than $45 $450,000 + $30,000 = $480,000
This strategy offers some extra premium income but leaves Jones subject to
substantial downside risk. At an extreme, if the stock price fell to zero, Jones

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would be left with only $30,000. This strategy also puts a cap on the final
value at $480,000, but this is more than sufficient to purchase the house.

b. By buying put options with a $35 strike price, Jones will be paying $30,000 in
premiums in order to ensure a minimum level for the final value of his
position. That minimum value is ($35 × 10,000) – $30,000 = $320,000.
This strategy allows for upside gain, but exposes Jones to the possibility of a
moderate loss equal to the cost of the puts. The payoff structure is:
Stock price Portfolio value
less than $35 $350,000 – $30,000 = $320,000
greater than $35 10,000 times stock price – $30,000

c. The net cost of the collar is zero. The value of the portfolio will be as follows:
Stock price Portfolio value
less than $35 $350,000
between $35 and $45 10,000 times stock price
greater than $45 $450,000
If the stock price is less than or equal to $35, then the collar preserves the
$350,000 principal. If the price exceeds $45, then Jones gains up to a cap
of $450,000. In between $35 and $45, his proceeds equal 10,000 times the
stock price.
The best strategy in this case would be (c) since it satisfies the two
requirements of preserving the $350,000 in principal while offering a chance
of getting $450,000. Strategy (a) should be ruled out since it leaves Jones
exposed to the risk of substantial loss of principal.
Our ranking would be: (1) strategy c; (2) strategy b; (3) strategy a.

16. Using Excel, with Profit Diagram on next page.

Stock Prices
Beginning Market Profit
Price 116.5 Price
Ending Market Price 130 Ending Straddle
Buying Options: 50 42.80
Call Options Strike Price Payoff Profit Return % 60 32.80
110 22.80 20.00 -2.80 -12.28% 70 22.80
120 16.80 10.00 -6.80 -40.48% 80 12.80
130 13.60 0.00 -13.60 -100.00% 90 2.80
140 10.30 0.00 -10.30 -100.00% 100 -7.20
110 -17.20
Put Options Strike Price Payoff Profit Return % 120 -27.20
110 12.60 0.00 -12.60 -100.00% 130 -37.20
120 17.20 0.00 -17.20 -100.00% 140 -27.20
130 23.60 0.00 -23.60 -100.00% 150 -17.20
140 30.50 10.00 -20.50 -67.21% 160 -7.20
170 2.80

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Straddle Price Payoff Profit Return % 180 12.80

110 35.40 20.00 -15.40 -43.50% 190 22.80
120 34.00 10.00 -24.00 -70.59% 200 32.80
130 37.20 0.00 -37.20 -100.00% 210 42.80
140 40.80 10.00 -30.80 -75.49%
Selling Options: Ending Bullish
Call Options Strike Price Payoff Profit Return % Stock
Price Spread
110 22.80 -20 2.80 12.28% 50 -3.2
120 16.80 -10 6.80 40.48% 60 -3.2
130 13.60 0 13.60 100.00% 70 -3.2
140 10.30 0 10.30 100.00% 80 -3.2
90 -3.2
Put Options Strike Price Payoff Profit Return % 100 -3.2
110 12.60 0 12.60 100.00% 110 -3.2
120 17.20 0 17.20 100.00% 120 -3.2
130 23.60 0 23.60 100.00% 130 6.8

140 30.50 10 40.50 132.79% 140 6.8

150 6.8
Money Spread Price Payoff Profit 160 6.8
Bullish Spread 170 6.8
Purchase 120 Call 16.80 10.00 -6.80 180 6.8
Sell 130 Call 13.60 0 13.60 190 6.8
Combined Profit 10.00 6.80 200 6.8
210 6.8

Profit diagram for problem 16:

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17. The farmer has the option to sell the crop to the government for a guaranteed
minimum price if the market price is too low. If the support price is denoted PS and
the market price Pm then the farmer has a put option to sell the crop (the asset) at
an exercise price of PS even if the price of the underlying asset (Pm) is less than PS.

18. The bondholders have, in effect, made a loan that requires repayment of B dollars,
where B is the face value of bonds. If, however, the value of the firm (V) is less
than B, the loan is satisfied by the bondholders taking over the firm. In this way,
the bondholders are forced to “pay” B (in the sense that the loan is cancelled) in
return for an asset worth only V. It is as though the bondholders wrote a put on an
asset worth V with exercise price B. Alternatively, one might view the bondholders
as giving the right to the equity holders to reclaim the firm by paying off the B
dollar debt. The bondholders have issued a call to the equity holders.

19. The manager receives a bonus if the stock price exceeds a certain value and
receives nothing otherwise. This is the same as the payoff to a call option.

20. a.
Position S T < 145 145  S T  150 S T > 150
Write call, X = $150 0 0 –(S T – 150)
Write put, X = $145 –(190 – S T) 0 0
Total S T – 145 0 150 – S T

Payoff
145 150
ST

Write put Write call

b. Proceeds from writing options:

Call: $4.10
Put: $3.60
Total: $7.70
If IBM sells at $153 on the option expiration date, the call option expires in
the money—cash outflow of $3, resulting in a profit of:
$7.70 – 3.00 = $4.70.

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If IBM sells at $160 on the option expiration date, the call option expires in
the money –cash outflow of $10, resulting in profit of:
$7.70 – $10.00 = -$2.30

c. You break even when either the put or the call results in a cash outflow of
-$1.24. For the put, this requires that:
$7.70 = $145.00 – S T  S T = $137.30
For the call, this requires that:
$7.70 = S T – $150.00  S T = $157.70

d. The investor is betting that IBM stock price will have low volatility. This
position is similar to a straddle.

21. The put with the higher exercise price must cost more. Therefore, the net outlay to
establish the portfolio is positive.

Position S T < 90 90  S T  95 S T > 95

Write put, X = $90 –(90 – S T) 0 0
Buy put, X = $95 95 – S T 95 – S T 0
Total 5 95 – S T 0
The payoff and profit diagram is:

5 Payoff

Net outlay to establish

position

0
ST
90 95

Profit

22. Buy the X = 62 put (which should cost more but does not) and write the X = 60 put.
Since the options have the same price, your net outlay is zero. Your proceeds at
expiration may be positive, but cannot be negative.

Position S T < 60 60  S T  62 S T > 62

Buy put, X = $62 62 – S T 62 – S T 0
Write put, X = $60 –(60 – S T) 0 0
Total 2 62 – S T 0

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Payoff = Profit (because net investment = 0)

0
ST
60 62

23. Put-call parity states that: P  C  S0  PV ( X )  PV (Dividends)

Solving for the price of the call option: C  S0  PV ( X )  PV (Dividends)  P
$100 $2
C  $100    $7
(1.05) (1.05)
 $9.86

24. a. The following payoff table shows that the portfolio is riskless with time-T value
equal to $10:

Position S T ≤ 10 S T > 10
Buy stock ST ST
Write call, X = $10 0 –(S T – 10)
Buy put, X = $10 10 – S T 0
Total 10 10
b. Therefore, the risk-free rate is: ($10/$9.50) – 1 = 0.0526 = 5.26%

25. a., b.

Position S T < 100 100  S T  110 S T > 110

Buy put, X = $110 110 – S T 110 – S T 0
Write put, X = $100 –(100 – S T) 0 0
Total 10 110 – S T 0
The net outlay to establish this position is positive. The put you buy has a
higher exercise price than the put you write, and therefore must cost more
than the put that you write. Therefore, net profits will be less than the payoff
at time T.

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10

Payoff

0
ST
100 110
Profit

c. The value of this portfolio generally decreases with the stock price. Therefore,
its beta is negative.

26. a. Joe’s strategy

Position Cost Payoff

S T  2,400 S T > 2,400
Stock index 2,400 ST ST
Put option, X = $2,400 120 2,400 – S T 0
Total -2,520 2,400 ST
Profit = payoff – $2,520 –120 S T – 2,520
Sally’s strategy

Position Cost Payoff

S T  2,340 S T > 2,340
Stock index 2,400 ST ST
Put option, X = $2,340 90 2,340 – S T 0
Total 2,490 2,340 ST
Profit = Payoff – $2,490 –150 S T – 2,490

b. Sally does better when the stock price is high, but worse when the stock price
is low.

c. Sally’s strategy has greater systematic risk. Profits are more sensitive to the
value of the stock index in that case.

27. a., b. (See graph)

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This strategy is a bear spread. Initial proceeds = $9 – $3 = $6

The payoff is either negative or zero:

Position S T < 50 50  S T  60 S T > 60

Buy call, X = $60 0 0 S T – 60
Write call, X = $50 0 –(S T – 50) –(S T – 50)
Total 0 –(S T – 50) –10

c. Breakeven occurs when the payoff offsets the initial proceeds of $6, which
occurs at stock price S T = $56. The investor must be bearish: the position does
worse when the stock price increases.

0 60
50 ST
-4 Profit

-10 Payoff

28. Buy a share of stock, write a call with X = $50, write a call with X = $60, and buy a
call with X = $110.
Position S T < 50 50  S T  60 60 < S T  110 S T > 110
Buy stock ST ST ST ST
Write call, X = $50 0 –(S T – 50) –(S T – 50) –(S T – 50)
Write call, X = $60 0 0 –(S T – 60) –(S T – 60)

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Buy call, X = $110 0 0 0 S T – 110

Total ST 50 110 – S T 0
The investor is making a volatility bet. Profits will be highest when volatility is low
and the stock price S T is between $50 and $60.

29. a.
Position S T ≤ 1,179 S T > 1,170
Buy stock ST ST
Buy put 1,170 – S T 0
Total 1,170 ST

Position S T ≤ 1,260 S T > 1,260

Buy call 0 S T – 1,260
Buy T-bills 1,260 1,260
Total 1,260 ST

b. The bills plus call strategy has a greater payoff for some values of S T and
never a lower payoff. Since its payoffs are always at least as attractive and
sometimes greater, it must be more costly to purchase.

c. The initial cost of the stock plus put position is $1,350 + $9 = $1,359
The initial cost of the bills plus call position is: $1,215 + $180 = $1,395

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S T = 1,000 S T = 1,260 S T = 1,350 S T = 1,440

Stock 1,000 1,260 1,350 1,440
+ Put 170 0 0 0
Payoff 1,170 1,260 1,350 1,440
Profit –189 –99 –9 81
Bill 1,260 1,260 1,260 1,260
+ Call 0 0 90 180
Payoff 1,260 1,260 1,350 1,440
Profit –135 –135 –45 +45

Profit

Protective put
Bills plus calls

1170 1260
ST
-135

-189

d. The stock and put strategy is riskier. This strategy performs worse when the
market is down and better when the market is up. Therefore, its beta is higher.

e. Parity is not violated because these options have different exercise prices.
Parity applies only to puts and calls with the same exercise price and
expiration date.

30. According to put-call parity (assuming no dividends), the present value of a

payment of $105 can be calculated using the options with January expiration and
exercise price of $105.
PV(X) = S0 + P – C
PV($105) = $100 + $6.94 – $2 =$104.93

Effective Annual Yield ( EAY ) :

n
 FaceValue f   105 12
EAY f        1.008 
 PV f
   104.93 
rf  .8%

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31. From put-call parity:

C – P = S0 – X/(l + rf )T
If the options are at the money, then S0 = X and
C – P = X – X/(l + rf )T
The right-hand side of the equation is positive, and we conclude that C > P.

CFA PROBLEMS

1. a. Donie should choose the long strangle strategy. A long strangle option
strategy consists of buying a put and a call with the same expiration date and
the same underlying asset, but different exercise prices. In a strangle strategy,
the call has an exercise price above the stock price and the put has an exercise
price below the stock price. An investor who buys (goes long) a strangle
expects that the price of the underlying asset (TRT Materials in this case) will
either move substantially below the exercise price on the put or above the
exercise price on the call. With respect to TRT, the long strangle investor
buys both the put option and the call option for a total cost of $9 and will
experience a profit if the stock price moves more than $9 above the call
exercise price or more than $9 below the put exercise price. This strategy
would enable Donie's client to profit from a large move in the stock price,
either up or down, in reaction to the expected court decision.

b. i. The maximum possible loss per share is $9, which is the total cost of the
two options ($5 + $4).
ii. The maximum possible gain is unlimited if the stock price moves outside
the breakeven range of prices.
iii. The breakeven prices are $46 and $69. The put will just cover costs if the
stock price finishes $9 below the put exercise price
(i.e., $55 − $9 = $46), and the call will just cover costs if the stock price
finishes $9 above the call exercise price (i.e., $60 + $9 = $69).

2. i. Equity index-linked note: Unlike traditional debt securities that pay a

scheduled rate of coupon interest on a periodic basis and the par amount of
principal at maturity, the equity index-linked note typically pays little or no
coupon interest; at maturity, however, a unit holder receives the original issue
price plus a supplemental redemption amount, the value of which depends on
where the equity index settled relative to a predetermined initial level.
ii. Commodity-linked bear bond: Unlike traditional debt securities that pay a
scheduled rate of coupon interest on a periodic basis and the par amount of
principal at maturity, the commodity-linked bear bond allows an investor to
participate in a decline in a commodity’s price. In exchange for a lower than

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market coupon, buyers of a bear tranche receive a redemption value that

exceeds the purchase price if the commodity price has declined by the
maturity date.

3. i. Conversion value of a convertible bond is the value of the security if it is

converted immediately. That is:
Conversion value = Market price of the common stock × Conversion ratio
= $40 × 22
= $880

ii. Market conversion price is the price that an investor effectively pays for the
common stock if the convertible bond is purchased:
Market conversion price = Market price of the convertible bond/Conversion ratio
= $1,050/22
= $47.73

4. a. i. The current market conversion price is computed as follows:

Market conversion price = Market price of the convertible bond/Conversion ratio
= $980/25
= $39.20
ii. The expected one-year return for the Ytel convertible bond is
Expected return = [(End of year price + Coupon)/Current price] – 1
= [($1,125 + $40)/$980] – 1
= 0.1888, or 18.88%
iii. The expected one-year return for the Ytel common equity is:
Expected return = [(End of year price + Dividend)/Current price] – 1
= ($45/$35) – 1 = 0.2857, or 28.57%

b. The two components of a convertible bond’s value are

1. The straight bond value, which is the convertible bond’s value as a bond.
2. The option value, which is the value from a potential conversion to
equity.
(i.) In response to the increase in Ytel’s common equity price, the straight
bond value should stay the same and the option value should increase.
The increase in equity price does not affect the straight bond value component
of the Ytel convertible. The increase in equity price increases the option value
component significantly, because the call option becomes deep “in the
money” when the $51 per share equity price is compared to the convertible’s

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CHAPTER 20: OPTIONS MARKETS: INTRODUCTION

conversion price of: $1,000/25 = $40 per share.

(ii.) In response to the increase in interest rates, the straight bond value should
decrease and the option value should increase.
The increase in interest rates decreases the straight bond value component
(bond values decline as interest rates increase) of the convertible bond and
increases the value of the equity call option component (call option values
increase as interest rates increase). This increase may be small or even
unnoticeable when compared to the change in the option value resulting from
the increase in the equity price.
5. a. (ii) [Profit = $40 – $25 + $2.50 – $4.00]
b. (i) The most the put writer can lose occurs when the stock price drops
completely to $0. This is a $40 loss less the $2 premium. The call writer will
keep the premium of $3.50 if the option finishes out of the money.

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