Solns-Study Problem Set 6

# Solns-Study Problem Set 6 - SOLUTIONS STUDY PROBLEM SET...

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SOLUTIONS, STUDY PROBLEM SET 6 (BKM, 8 TH ED) Chapter 20 10. a. Position S T < X 1 X 1 S T X 2 X 2 < S T X 3 X 3 < S T Long call (X 1 ) 0 S T – X 1 S T – X 1 S T – X 1 Short 2 calls (X 2 ) 0 0 –2(S T – X 2 ) –2(S T – X 2 ) Long call (X 3 ) 0 0 0 S T – X 3 Total 0 S T – X 1 2X 2 – X 1 – S T (X 2 –X 1 ) – (X 3 –X 2 ) = 0 X 2 – X 1 S T X 1 X 2 Payoff X 3 b. Position S T < X 1 X 1 S T X 2 X 2 < S T Buy call (X 2 ) 0 0 S T – X 2 Buy put (X 1 ) X 1 – S T 0 0 Total X 1 – S T 0 S T – X 2 X 1 S T X 1 X 2 Payoff 1

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12. a.By writing covered call options, Jones receives premium income of \$30,000. If, in January, the price of the stock is less than or equal to \$45, then Jones will have his stock plus the premium income. But the most he can have at that time is (\$450,000 + \$30,000) because the stock will be called away from him if the stock price exceeds \$45. (We are ignoring here any interest earned over this short period of time on the premium income received from writing the option.) The payoff structure is: Stock price Portfolio value less than \$45 10,000 times stock price + \$30,000 greater than \$45 \$450,000 + \$30,000 = \$480,000 This strategy offers some extra premium income but leaves Jones subject to substantial downside risk. At an extreme, if the stock price fell to zero, Jones would be left with only \$30,000. This strategy also puts a cap on the final value at \$480,000, but this is more than sufficient to purchase the house. b.
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Solns-Study Problem Set 6 - SOLUTIONS STUDY PROBLEM SET...

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