1 Question 1 . Suppose the market price of a stock is So at time to- . The stock

Question

1 Question 1 . Suppose the market price of a stock is So at time to- . The stock does not pay dividends . The interest rate is r >0 (a constant) . All the options below have strike K >0 and expiration time T> te- 1.1 European call Assume that the value of the stock price is S>0.1. . Assume that the value of the strike price is K>O.leT-) .A European call trades today (time to) at a market price So-0.1 . We formulate a trading strategy as follows: (a) buy the call, (b) short sell one share of stock (c) save money in a bank. . The initial value of our portfolio is zero. Find a scenario where this strategy leads to a profit. Find a scenario where this strategy leads to a loss. .Note: if we do not exercise the option, we must buy back the stock, to cover the short sale. 1.2 American call . Assume that the value of the stock price is S1. * Assume that the value of the strike price is K > 0.1er(T-6) * An American call trades today (time to) at a market price = S,-0.1. We formulate a trading strategy as follows: (a) buy the call, (b) short sell one share of stock (c) save money in a bank. .The initial value of our portfolio is zero. Find a scenario where this strategy leads to a profit. .Find a scenario where this strategy leads to a loss. .Note: if we do not exercise the option, we must buy back the stock, to cover the short sale.

Explanation / Answer

1. European call: European call option can be exercised at the time of maturity only

1.1 stock price: So>1

Strike price: K>0.1e^t(T-t0)

Market price or spot price: So-0.1

a)Strategy leads profit when we buy the call at higher spot price and lower strike price. For instance, if the spot price is $ 75 and the strike price is $50, it's better to exercise call option and make neat Rs $25 as profit.

b)strategy leads to loss when we exercise a call option at lower spot price as compared to strike price.For instance, if the spot price is $30 and the strike price is $50, as we exercise option we face loss in the strategy.

c) if we save money in the bank we can earn assured in interest which is risk-free as compared to investing in the stock.

2.Amercian Option: American option can be exercised during the tenure.

1.Buy call: The strategy leads profit when the spot price is more than the strike price plus premium which is in the current scenario.

2.when short sell one of the share: if we short sell the share at the present situation it will lead to the loss since strike price is lower than the market price.

3.Save money in the bank: since r>0 we can get limited but assured return on the money which may have downside risk while making investment in stock through option.

Related Questions

Navigate

• Browse (All)
• Browse 1
• Subjects

---

---

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