Below is some information on two put options, both of which expire in 1 year. Th
ID: 2784819 • Letter: B
Question
Below is some information on two put options, both of which expire in 1 year. The risk-free rate is 1%.
(A) If an arbitrage strategy is needed to construct here, which option does it need to be bought and which option does it need to be sold? Draw a gross payoff diagram based on this strategy and explain what this diagram demonstrates about the risk exposure to the underlying stock?
(B) If a delta-neutral strategy is needed to construct, what is the ratio of the number of options that must be bought to the number of options that must be sold?
Stock price Strike Price Put price Implied vol $72 $70.00 $7.70 32% $72 $72.50 $7.89 28%Explanation / Answer
a. You buy the second option and sell the first option.This is because the second option strike price is higher than stock price while in the first option you sell because the stock price is higher than the strike price.
b. The ratio of number of option must be bought to the number of options that must be sold is 28/32*100= 87.5%
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