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    Developing econometric models for macroeconomic variables

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    Your firm has a well-respected economic research staff. The staff members have been successful in developing econometric models that can predict macroeconomic variables with a surprisingly degree of accuracy. The economic research staff would like to know which variables to monitor if options are ultimately used by the firm. Write a 2-3 page document to Mr. Herman explaining how the listed variables impact the prices of put options and what the associated theory is behind each relationship:

    exercise price
    stock price
    implied volatility
    It is also important to recognize if put-call parity conditions are being met; if not, an arbitrage opportunity exists for the firm. In the following situation, identify whether or not an arbitrage opportunity exists if

    call price = $1.15.
    exercise price = $22.50.
    time to expiration = 17 days.
    put price = $0.55.
    annual interest rate = 1.2%.
    the stock pays zero dividends.

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    Solution Preview

    Impact of variables on put option:
    Exercise price: For a put option, the payoff on the exercise is based on the amount by which the strike price exceeds the stock price. The put option becomes less valuable as the stock price increases from the strike price and more valuable when the strike price increase for that put option.
    Time of Expiration: For put American option, the value of the option increases as the time of expiration of that option increases. The main reason behind this is the owner of the life long option holder has all the exercise opportunities available as compared to the short term option. This is the reason the long term put option is more valuable than the short term put option.
    For European put option, it's not always possible ...

    Solution Summary

    The solution examines developing econometric models for macroeconomic variables.