Stock ABC and Stock XYZ have the same current price of $50, and they offer the s

Question

Stock ABC and Stock XYZ have the same current price of $50, and they offer the same distribution of future returns (with the same expected return and the same standard deviation). There exists a call option on one share of Stock ABC and a call option on one share of Stock XYZ. The options have identical exercise prices of $49 and they expire on the same date. The call premium on each option is $3. A.) Are the options currently “in” or “out” of the money? B.) What is the intrinsic value and the time value of each option today? C.) What is the break-even future stock price associated with the options? D.) What is the net profit or loss associated with purchasing either option if the future stock price is $30. E.) What is the net profit or loss associated with writing either option if the future stock price is $48? F.) What is the net profit or loss associated with writing either option if the future stock price is $51? G.)What is the net profit or loss associated with writing either option if the future stock price is $80? H.) Assume that there is a third call option, based on the average price of Stocks ABC and XYZ, with the same expiration date as the first two options. The exercise price of this option is $49. Should the price (call premium) of the third option be higher than, lower than, or equal to the prices of the two options on the individual stocks in the following two cases? (Briefly explain your answer in each case). -The correlation between the returns of the ABC and XYZ is +1 -The correlation between the returns of the two stocks is +0.3

Explanation / Answer

A) The options are currently in the money, because for a call option,the option's strike price is below the market price of the underlying asset.

B)

The intrinsic value of a call option is the difference between the strike price and the market price when the option is in the money.

If we subtract the intrinsic value from the premium, the difference is the time value of the call option.

C)

We purchased a call option with a strike price of $49. We paid $3 per share for the option contract, of which $1 was intrinsic value and the remaining dollar was the time value. If we add the premium paid to the strike price, we get $52. If the market price reaches $52 before the option expires, we can exercise the option and get all of our money back. Now, subtract the strike price from $52. we get $3, which is the intrinsic value the call option must have for we to break even. Anything over an intrinsic value of $3 is profit.

D)

Stock ABC Stock XYZ Current Price 50 50 Exercise price of call option                                     49                       49

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