Tutorial 5 Solutions for Principles of Finance

1. Factors that affect option prices

The share price S0=$30 is much lower than the strike price K=$50. In this case, the prob- ability
that the share price will exceed the strike price in a week is very low. The option is deep out-
of-the money.1 In other words, it is very unlikely that this option will be exercised. Consequently,
you should have paid a low price to purchase it.
(a) When S0=$100, the call option is deep in-the-money. It is very likely that the share
price will stay above the strike price when the option expires in a week. You would pay more
for the option in this case, since with a very high probability you will be able to purchase
the Wal-Mart share below its market value.
The price of a call option tends to increase as the underlying stock’s price increases.
(b)When K=$30, the call option is at-the-money. There is a fair chance that the share
price might exceed the strike price when the option expires in a week. You would pay more for
the at-the-money call option with K=$30 than the deep out-of-the-money one with K=$50, since
the at-the-money call option is more likely to be exercised.
A lower strike price implies a higher call price.
(c) We argued that when S0=$30 and K=$50, the call option is unlikely to be exercised.
Implicit behind this argument is the belief that the share price of Wal-Mart will probably not
increase by 66.66% (=($50/$30)-1) in a week. However, suppose for the sake of argument
that there is a sudden shift in the volatility of Wal-Mart share prices and investors now
believe that such an increase is quite possible. In such a case you would pay more for the
call option, as it becomes more likely to be exercised.
The price of a call option tends to increase if the volatility of the share price increases.
(d) For the call option, we argued that you would pay more if S0=$100 rather than
S0=$30. For the put option, the opposite is true. When S0=$30 the put option is deep
in-the-money, but if S0=$100, it becomes deep out-of-the-money. You would pay very little
for the deep out-of-money put option.
The price of a put option tends to decrease as the underlying stock’s price increases.
(e) For the call option, we argued that you would pay more if K=$30 rather than K=$50. For
the put option, again, the opposite is true. The put options is deep in-the-money when K=$50,
but only at-the-money when K=$30. Even though the at-the-money put option is valuable, it is
worth less than the deep in-the-money one. Therefore, you would pay less for it.
A lower strike price implies a lower put price.
1Note that the adjective “deep” is used loosely. It suggests that the share price and the strike price are

significantly apart.

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 (f) The prices of call and put options reacted in an opposite way to changes in S0 and
K. However, they react in the same way to changes in volatility of share prices. Consider
the put option in part (d), where S0=$100 and K=$50. We argued that this option is deep
out-of-the-money because of the belief that the share price of Wal-Mart will probably not
decrease by -50.00% (=($50/$100)-1) in a week. However, again, suppose there is a sudden
shift in the volatility of Wal-Mart shares such that a weekly return of -50.00% becomes quite
possible. In such a case you would pay more for the put option, as it becomes more likely to
be exercised.
The price of a put option tends to increase if the volatility of the share price increases.

2. Long versus short positions in option contracts

Parts (a) and (d) of Question 1 showed that, all else equal, an increase in the stock price
makes the exercise of a call option more likely and that of a put option less likely. In this
question, let’s assume that the strike price is K=$20 and at the time you entered the option
contract the stock price was S0=$20. Therefore, at that time the option contract was at- the-
money. Furthermore, let’s assume that after 11 months the stock price has gone up to
$40. This suggests that, now, the option is deep in-the-money if it is a call and deep out-of-
the-money if it is a put. Finally, let’s assume that the call option price was C0=$5, the put
option price was P0=$1, and the risk-free interest rate is rf = 25% per year.2
(a) If you are the call option seller, you would be unhappy about the share price increase.
The reason is, the call option is deep in-the-money. If the stock price stays at $40 until the option
contract’s expiry, the option buyer would exercise his option, and you would have to pay $40 to
buy the stock from the market and sell it for only $20 to the option buyer. Then, your final
payoff (assuming that the stock price will indeed be $40 when the option expires) can be
calculated as follows: 3

Final payoff = (1 + rf )C0 − max(SF − K, 0) = 1.25($5) − max($40 − $20, 0) = −$13.75

Figure 1a shows that when you have a short position in a call option, you lose from the increases
in the stock price.
(b) If you are the put option seller, you would be happy about the share price increase. This
is due to the fact that the put option is deep out-of-the-money. If the stock price stayed at $40
until the option’s expiry, the option buyer would not exercise his option. You would make a
profit, since the option buyer paid you the price of the put option at the time when
2You can use put-call parity to verify that call and put option prices are consistent: C0 = P0+S0−K/(1+rf ).

The right hand side of the parity is: P0 + S0 − K/(1 + rf ) = $1 + $20 - $20/(1.25) = $5. It is equal to the
left hand side of the parity C0 = $5. There would be an arbitrage opportunity if this parity did not hold. See
pages 684 and 685 of your textbook for a detailed explanation.
3The option buyer paid you C0 =$5, and we assume that you deposited this money into a bank for 1 year.

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you entered the contract. Your payoff (assuming that the stock price will indeed be $40 when
the option expires) would be: 4

Final payoff = (1 + rf )P0 − max(K − SF , 0) = 1.25($1) − max($20 − $40, 0) = $1.25

Figure 1b shows that when you have a short position in a put option, you gain from the increases
in the stock price.
(c) If you are the call option buyer, you would be happy about the share price increase.
If the stock price stayed at $40 until the option’s expiry, you would exercise your option and
buy the stock for only $20 from the option seller. Then, you could sell this stock for $40 in the
market. This yields a final payoff (assuming that the stock price will indeed be $40 when the
option expires) of: 5

Final payoff = max(SF − K, 0) − (1 + rf )C0 = max($40 − $20, 0) − 1.25($5) = $13.75

Figure 1c shows that when you have a long position in a call option, you gain from the increases
in the stock price.
(d) If you are the put option buyer, you would be unhappy about the share price increase.
If the stock price stayed at $40 until the option’s expiry, you would not exercise your option.
You would make a loss, since you paid the put option price when you entered into the contract.
Then, (assuming that the stock price will be indeed $40 when the option expires) your payoff
would be:6

Final payoff = max(K − SF , 0) − (1 + rf )P0 = max($20 − $40, 0) − 1.25($1) = −$1.25

Figure 1d shows that when you have a long position in a put option, you lose from the increases
in the stock price.

3. Using BOPM to price a call option

In this question, we can apply the Binomial Option Pricing Model. This is because the oil
price takes only two possible values next year. We need to form a replicating portfolio using
the underlying asset (i.e., oil) and a risk-free asset (i.e., a government bond or a bank account).
In a competitive market, the cost of forming this portfolio yields the price of the option, since
if this was not the case, there would be an arbitrage opportunity. The question provides the
following information: S0=$80, Su=1.25($80)=$100, Sd=0.75($80)=$60, rf =5%, K={$80,
$90, $100}.
4Again, we assume that you deposit the money you earn from the contract, which is P0=$1.
5We assume that you borrowed $5 from the bank to pay for the call option price. At the end of the year,
you need to pay the bank back 1.25 ($5)=$6.25 in order to retire your loan.
6We assume that you borrowed $1 from the bank to pay for the put option price. So you have to pay the

bank back 1.25 ($1)=$1.25 after a year.

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 (a) Short call (b) Short put

(c) Long call (d) Long put

Figure 1: Option payoffs at expiry. Panel 1a (1b) depicts the payoff at expiry of a short position in a
call (put) option. Panel 1c (1d) depicts the payoff at expiry of a long position in a call (put) option.

(a) If the strike price is K=$80, then the call option’s payoffs at the expiry are: Cu =
max(Su − K, 0) = max($100-$80, 0) = $20 and Cd = max(Sd − K, 0) = max($60-$80, 0) =
$0. Then:
∆ = Cu − Cd = $20 − $0 = 0.5 (1)
Su − Sd $100 − $60
and

B = Cd − ∆Sd = $0 − 0.5($60) = −$28.5714 (2)

1 + rf 1.05
Let’s verify whether we can replicate the payoffs of the call option by purchasing 0.5 units of
the underlying asset and by borrowing $28.5714 from a bank:

∆ × Su + 1.05 × B = 0.5 × $100 + 1.05 × (−$28.5714) = $20 = Cu ✓

∆ × Sd + 1.05 × B = 0.5 × $60 + 1.05 × (−$28.5714) = $0 = Cd ✓

Then, the call option price is the cost of forming the replicating portfolio:

C0 = ∆ × S0 + B = 0.5 × $80 − $28.5714 = $11.4286

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 (b) If the strike price is K = $90, then the call option’s payoffs at the expiry are: Cu =
max(Su − K, 0) = max($100 − $90, 0) = $10 and Cd = max(Sd − K, 0) = max($60 − $90, 0) =
$0. Then:
∆ = Cu − Cd = $10 − $0 = 0.25 (3)
Su − Sd $100 − $60
and

Cd − ∆Sd $0 − 0.25($60)
B= = = −$14.2857 (4)
1 + rf 1.05
Let’s verify whether we can replicate the payoffs of the call option by purchasing 0.25 units of
the underlying asset and by borrowing $14.2857 from a bank:

∆ × Su + 1.05 × B = 0.25 × $100 + 1.05 × (−$14.2857) = $10 = Cu ✓

∆ × Sd + 1.05 × B = 0.25 × $60 + 1.05 × (−$14.2857) = $0 = Cd ✓

Then, the call option price is the cost of forming the replicating portfolio:

C0 = ∆ × S0 + B = 0.25 × $80 − $14.2857 = $5.7143

(c) If the strike price is K=$100, then the call option’s payoffs at the expiry are: Cu =
max(Su − K, 0) = max($100 − $100, 0) = $0 and Cd = max(Sd − K, 0) = max($60-$100, 0) =
$0. The call option is worthless in this case as it yields $0 in both cases. Therefore, without
even forming the replicating portfolio, we can conclude that C0=$0. No rational investor would
pay for an option which they know for certain that they will not exercise.
Notice that, as we have increased the strike price from $80 to $90, and then from $90 to
$100, the call option price has decreased from $11.4286 to $5.7143, and then from $5.7143 to
$0. This is consistent with our argument in Part (b) of Question 1.
Also, notice the motivation for buying a call option in this context. The question stresses
that oil is an important input for your company. This means that you would like to purchase
oil at the lowest price possible. Thus, you are using a call option to hedge the risk against
future increases in the oil price.

4. Using BOPM to price a put option

We apply the Binomial Option Pricing Model in this question as well. The parameter values are
the same as in Question 3: S0 = $80, Su = 1.25($80) = $100, Sd=0.75($80)=$60, rf =
5%, K={$80, $90, $100}. The only difference is that we are now pricing a put option, instead
of a call option.
(a) If the strike price is K=$80, then the put option’s payoffs at the expiry are: Pu =
max(K − Su, 0) = max($80-$100, 0) = $0 and Pd = max(K − Su, 0) = max($80-$60, 0) =
$20. Then:
P − Pd $0 − $20
∆= u = = −0.5
Su − Sd $100 − $60
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and
Pd − ∆Sd $20 + 0.5($60)
B= = = $47.61905
1 + rf 1.05
Let’s verify whether we can replicate the payoffs of the call option by short selling 0.5 units
of the underlying asset and by lending $47.61905 to a bank:

∆ × Su + 1.05 × B = −0.5 × $100 + 1.05 × ($47.61905) = $0 = Pu ✓

∆ × Sd + 1.05 × B = −0.5 × $60 + 1.05 × ($47.61905) = $20 = Pd ✓

Then, the put option price is the cost of forming the replicating portfolio:

P0 = ∆ × S0 + B = −0.5 × $80 + $47.61905 = $7.61905

(b) If the strike price is K = $90, then the put option’s payoffs at the expiry are: Pu =
max(K − Su, 0) = max($90 − $100, 0) = $0 and Pd = max(K − Su, 0) = max($90 − $60, 0) =
$30. Then:
Pu − Pd $0 − $30
∆= = = −0.75
Su − Sd $100 − $60
and

Pd − ∆Sd $30 + 0.75($60)

B= 1 + rf = 1.05 = $71.42857

Let’s verify whether we can replicate the payoffs of the call option by short selling 0.75 units
of the underlying asset and by lending $71.42857 to a bank:

∆ × Su + 1.05 × B = −0.75 × $100 + 1.05 × ($71.42857) = $0 = Pu ✓

∆ × Sd + 1.05 × B = −0.75 × $60 + 1.05 × ($71.42857) = $30 = Pd ✓

Then, the put option price is the cost of forming the replicating portfolio:

P0 = ∆ × S0 + B = −0.75 × $80 + $71.42857 = $11.42857

(c) If the strike price is K = $100, then the put option’s payoffs at the expiry are:
Pu = max(K − Su, 0) = max($100 − $100, 0) = $0 and Pd = max(K − Su, 0) = max($100 −
$60, 0) = $40. Then:
P − Pd $0 − $40
∆= u = = −1
Su − Sd $100 − $60
and

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 Pd − ∆Sd $40 + 1($60)
B= = = $95.2381
1 + rf 1.05
Let’s verify whether we can replicate the payoffs of the call option by short selling 1 unit of
the underlying asset and by lending $95.2381 to a bank:

∆ × Su + 1.05 × B = −1 × $100 + 1.05 × ($95.2381) = $0 = Pu ✓

∆ × Sd + 1.05 × B = −1 × $60 + 1.05 × ($95.2381) = $40 = Pd ✓

Then, the put option price is the cost of forming the replicating portfolio:

P0 = ∆ × S0 + B = −1 × $80 + $95.2381 = $15.2381

Notice that, as we have increased the strike price from $80 to $90, and then from $90 to
$100, the put option price has increased from $7.61905 to $11.42857, and then from $11.42857
to $15.2381. This is consistent with our argument in Part (e) of Question 1.
Also, notice the motivation for buying a put option in this context. The question stresses
that oil is an important output for your company. This means that you would like to sell
oil at the highest price possible. Thus, you are using a put option to hedge the risk against
future decreases in the oil price.