Chapter 4

4.1 You own a call option on Intuit stock with a strike price of $40. The option will
expire in exactly three months’ time.
a. If the stock is trading at $55 in three months, what will be the payoff of the call?
b. If the stock is trading at $35 in three months, what will be the payoff of the call?
c. Draw a payoff diagram showing the value of the call at expiration as a function of
the stock price at expiration.
4.2 Assume that you have shorted the call option in Problem 4.1.
a. If the stock is trading at $55 in three months, what will you owe?
b. If the stock is trading at $35 in three months, what will you owe?
c. Draw a payoff diagram showing the amount you owe at expiration as a function of
the stock price at expiration.
4.3 You own a put option on Ford stock with a strike price of $10. The option will
expire in exactly six months’ time.
a. If the stock is trading at $8 in six months, what will be the payoff of the put?
b. If the stock is trading at $23 in six months, what will be the payoff of the put?
c. Draw a payoff diagram showing the value of the put at expiration as a function of
the stock price at expiration.
4.4 Assume that you have shorted the put option in Problem 4.3.
a. If the stock is trading at $8 in three months, what will you owe?
b. If the stock is trading at $23 in three months, what will you owe?
c. Draw a payoff diagram showing the amount you owe at expiration as a function of
the stock price at expiration.
4.5 Suppose you buy a one-year European call option on Wombat shares with an
exercise price of $100 and sell a one-year European put option with the same exercise price.
The current share price is $100, and the interest rate is 10%.
a. Draw a payoff diagram showing the payoffs from your investments.
b. How much will the combined position cost you? Explain.
4.6 Suppose that Mr. Colleoni borrows the present value of $100, buys a six-month put
option on share Y with an exercise price of $150, and sells a six-month put option on Y
with an exercise price of $50.
a. Draw a payoff diagram showing the payoffs when the options expire.
b. Suggest two other combinations of loans, options, and the underlying stock that
would give Mr. Colleoni the same payoffs.

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 4.7 Option traders often refer to “straddles” and “butterflies.” Here is an example of
each:
∙ Straddle: Buy one call with exercise price of $100 and simultaneously buy one put
with exercise price of $100.
∙ Butterfly: Simultaneously buy one call with exercise price of $100, sell two calls with
exercise price of $110, and buy one call with exercise price of $120.
Draw payoff diagrams for the straddle and butterfly, showing the payoffs from the
investor’s net position. Each strategy is a bet on variability. Explain briefly the nature of
each bet.
4.8 An investor buys a stock for $36. At the same time a six-month put option to sell
the stock for $35 is selling for $2.
a) What is the profit or loss from purchasing the stock if the price of the stock is $30,
$35, or $40?
b) If the investor also purchases the put (i.e., constructs a protective put), what is the
combined cash outflow?
c) If the investor constructs the protective put, what is the profit or loss if the price
of the stock is $30, $35, or $40 at the put’s expiration? At what price of the stock
does the investor break even?
d) What is the maximum potential loss and maximum potential profit from this
protective put?
e) If, after six months, the price of the stock is $37, what is the investor’s maximum
possible loss?
4.9 If you anticipate that the price of a stock will rise, you could (1) buy the stock, (2)
buy a call, (3) sell a covered call, or (4) sell a put. All four positions may generate profits
if the price of the stock rises, but the cash inflows or outflows, the amount of any gains, and
the potential losses differ for each position. Currently, the price of a stock is $86; four- month
calls and puts with a strike price of $85 are trading for $10.50 and $8.25, respectively.
a) What are the cash inflows or outflows associated with each of the four positions?
b) Construct a profit/loss profile for each position at the following prices of the stock.

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 Profit/Loss
Price of the Stock Bought the Stock Covered Call Bought the Call Sold the Put
$110
100
95.50
90
86
80
76.75
75.50
70
65
As this profile illustrates, each strategy produces a gain but the amounts and potential
losses differ.
c) What are the prices of the stock that generate breakeven for each position?
d) Compare the cash inflows/outflows, profits, and potential loss from the covered call
and sale of the put. Which is better if you are able to invest any cash inflows and earn $1.25?
e) Which strategy has the smallest potential dollar loss?
f) What price of the stock produces a loss on all four positions?
g) Which position generates the highest possible gain in dollars and in percentage terms?
h) Suppose the price of the stock declines, and the put is exercised (i.e., you have to
buy the stock). Since the option is exercised, what is your cost basis of the stock?
Compare this cost basis to your initially buying the stock instead of selling the put.
4.10 The futures price of corn is $2.00. The contracts are for 10,000 bushels, so a
contract is worth $20,000. The margin requirement is $2,000 a contract, and the
maintenance margin requirement is $1,200. A speculator expects the price of the corn to
fall and enters into a contract to sell corn.
a) How much must the speculator initially remit?
b) If the futures price rises to $2.13, what must the speculator do?
c) If the futures price continues to rise to $2.14, how much does the speculator have in
the account?
4.11 The futures price of gold is $1,750. Futures contracts are for 100 ounces of gold,
and the margin requirement is $5,000 a contract. The maintenance margin requirement is
$1,500. You expect the price of gold to rise and enter into a contract to buy gold.
a) How much must you initially remit?
b) If the futures price of gold rises to $1,755, what is the profit and percentage return
on your position?
c) If the futures price of gold declines to $1,748, what is the loss and percentage return
on the position?
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 d) If the futures price falls to $1,738, what must you do?
e) If the futures price continues to decline to $1,710, how much do you have in your
account?
f) How do you close your position?
4.12 The futures price of British pounds is $2.00. Futures contracts are for £10,000,
so a contract is worth $20,000. The margin requirement is $2,000 a contract, and the
maintenance market requirement is $1,200. A speculator expects the price of the pound to
fall and enters into a contract to sell pounds.
a) How much must the speculator initially remit?
b) If the futures price rises to $2.13, what must the speculator do?
c) If the futures price continues to rise to $2.14, how much does the speculator have in
the account?