3 Question 3 For each case below, you are the trader on the opposite side of the

Question

3 Question 3 For each case below, you are the trader on the opposite side of the trade with me at time to0) For each case below, state the trade you will perform with me at time to0) For each case, you must explain the reason for your trading decision. In all cases, both you and I begin with a portfolio of zero (no cash, no stock, options, etc.) 1. Money required to buy things must be borrowed from me. Interest must be paid on the loan 2. Money received by selling things is loaned to me. I will pay interest on the savings. 3. The borrow and lend interest rates are equal. Both are equal to the risk-free rate. 4. There is no limit on the quantity to buy or sell anything, including short selling of stock In a the cases below: I. The current value of the stock price is So = 100. 2. The stock does not pay dividends. 3. For questions involving a stock index, therent value of the index is 1000 points. 4· The stock index has a continuous dividend yield of 1.5%. 5·The interest rate is 5% (borrow and lend rates are equal). 6. All the options have the same expiration time of 1 year. 7. All the forward/futures contracts have the same expiration time of 1 year. See next page.

Explanation / Answer

3.4.1

Stock Volatility is 30% that means it will trade between $970-$1030

I will buy the call option at $75 with as strike price of $900.

Since its a volatile market, I would like to have a strategy in which my loss is limited. Currently it being limited to the premium paid on call option i.e. $75.

The index is currently trading at $1000, which mean that the option is in the money and is an american call option implies that it can be exercised anytime. I will buy a call option and profit from the execution of the contract when the stock price rises above $1,000 and immediately sell in the open market so that I earn the profit without having the interest burden. Even in current scenario with index priced at $1000, profit will be $25.

3.4.2

I will long the put option as the option is in the money

If upon expiration, Index closes below the strike of 1050, I would exercise his option and profit to the extent of the difference between the strike price and index close. The profits possible on this option would be limited to ($1050-$1000-$35 for premium = $15. However if Index rises above the strike of 1050,I will let the option expire and limit my loss to the extent of the premium of $35

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