Problem 22-28 Two-State Option Pricing Model Maverick Manufacturing, Inc., must

Question

Problem 22-28 Two-State Option Pricing Model Maverick Manufacturing, Inc., must purchase gold in three months for use in its operations. Maverick’s management has estimated that if the price of gold were to rise above $1,555 per ounce, the firm would go bankrupt. The current price of gold is $1,475 per ounce. The firm’s chief financial officer believes that the price of gold will either rise to $1,655 per ounce or fall to $1,365 per ounce over the next three months. Management wishes to eliminate any risk of the firm going bankrupt. Maverick can borrow and lend at the risk-free EAR of 5.5 percent. a-1. Should the company buy a call option or a put option on gold? Call option Put option a-2 What strike price would the company like this option to have? (Do not round intermediate calculations.) Strike price b. How much should such an option sell for in the open market? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Option price $ c. Suppose no options currently trade on gold. What are the transactions needed to create a synthetic option with identical payoffs to a traded option? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16)) c-1. $ shares of stock c-2. Amount to $ d. How much does the synthetic option cost? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Synthetic option $

Explanation / Answer

Answer a-1 & a-2

Maverick Manufacturing Inc. should purchase call option of gold with strike price of $ 1,555 because call option will cover the maximum risk of bankruptsy. If gold's price remains low in three months then Maverick Manufacturing Inc. will buy gold from market and call option will expire. If price of gold rises above $ 1,555 than Maverick manufacturing Inc will exercise gold option and will receive payoff. so, in this case by buying call option of $ 1,555 Maverick Manufacturing Inc. will limit it's risk at $ 1,555

Related Questions

Navigate

• Browse (All)
• Browse P
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.