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How would you take advantage of this great opportunity? Now suppose the option is a European call. What would you do?

4 Questions for you to familiarize with option and warrants, especially the Call/Put Parity, formula and relations.

Question 1
Pintail's stock price is currently $200. A one-year American call option has an exercise price of $50 and is priced at $75. How would you take advantage of this great opportunity? Now suppose the option is a European call. What would you do?

Question 2
In June 2001 a six-month call on Intel stock, with an exercise price of $22.50, sold for $12.30. The stock price was $27.27. The risk-free interest rate was 3.9 percent. How much would you be willing to pay for a put on Intel stock with the same maturity and exercise price?

Question 3
Suppose that Mr. Colleoni borrows the present value of $100, buys a six-month put
option on stock Y with an exercise price of $150, and sells a six-month put option on Y with an exercise price of $50. Suggest two other combinations of loans, options and the underlying stock that would give Mr. Colleoni the same payoffs.

Question 4
a.) If you can't sell a share short, you can achieve exactly the same final payoff by a combination of options and borrowing or lending. What is this combination?

b.) Now work out the mixture of stock and options that gives the same final
payoff as a risk-free loan.

Solution Preview

Question 1
You would buy the American call for $75, exercise the call immediately in
order to purchase a share of Pintail stock for $50, and then sell the share of
Pintail stock for $200. The net gain is: [$200 - ($75 + $50)] = $75.

If the call is a European call, you should buy the call, deposit in the bank an
amount equal to the present value of the exercise price, and sell the stock
short. This produces a current cash flow equal to: [$200 - $75 - ($50/1 + r))].
At the maturity of the call, the action depends on whether the stock price is
greater than or less than the exercise price. If the stock price is greater than
$50, then you would exercise the call (using ...

Solution Summary

Here is just a sample of what you will find in the solution:

"This implies that, in order to replicate a short sale of a share of stock, you would purchase a put, sell a call, and borrow the present value of the exercise price."

$2.19