1 Question 1 Suppose the market price of a stock is So at time to. . The stock d
ID: 2781894 • Letter: 1
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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> to 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>0.1eTt) A European call trades today (time to) at a market price So-0.1. We formulate a trading strategy as folldws: (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 So >0.1 . Assume that the value of the strike price is K>O.leT-to) . An Am erican 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.Explanation / Answer
Answers...
European Call
1.1
a) The investor will earn profit when the price of the stock at expiry is less than the sum of
(Strike Price + Price paid for the option - Interest earned from the short sell)
b)The startegy would lead to a loss when
The price of the stock rises at expiry and the investor would need to purchase the stock to make up for the short sell commitment.
1.2 American Call
In this case the investor will earn profit in a bearish market when the stock price is falling. The investor can exercise the option as and when at the time of execution of the option, the stock price is equal to
(Strike Price + Price paid for the option - Interest earned from the short sell)
b) The startegy would lead to a loss when
The price of the stock is rising and at the time of execution of the contract, the investor would need to purchase the stock to make up for the short sell commitment.
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