Lecture #4 - Ec 136 Financial Economics Lecture 4 September...

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Ec 136, Financial Economics Lecture 4 September 8
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Outline for today 1. Law of one price. 2. Call and put options. 3. Put-call parity. www.econ.berkeley.edu/~szeidl/ec136/ec136index.htm Readings for this week: BKM Chapter 20.1, 20.2, 20.4
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1. Law of one price ° Redundant assets have payo°s that can also be obtained by combining other assets. Asset 1 Asset 2 Asset 3 State 1 0 1 5 State 2 2 0 6 Price P 1 P 2 P 3 ° Is there a redundant asset in this economy? ° Can you determine the price P 3 of asset 3 using P 1 and P 2 ? ° Law of one price : assets with identical payo°s tmw should have the same price today.
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2. Calls and puts ° European call : right, but not the obligation, to buy an asset at ±xed price on given future date. ° E.g., suppose that IBM sells for S 0 = $50 today. ° You buy a call for price C 0 = $10 with exercise of X = $60 and expiration in six months. 1. If price of IBM goes to S T = $40, don’t exer- cise call: why pay $60 for a $40 stock? 2. If price of IBM goes to S T = $80, exercising means that you can buy a $80 security for $60.
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