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Chapter5

# Chapter5 - Chapter Five Option Pricing Answers to Problems...

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Chapter Five Option Pricing Answers to Problems and Questions 1. Arbitrage is the existence of a riskless profit, especially when you do not have to commit funds to earn the profit. 2. Market prices move continually, and frequently move slightly away from an equilibrium price. It is the actions of arbitrageurs that move them back to their proper level. 3. Given the €/\$ and €/AuD exchange rates, an Australian dollar should cost \$1.15/\$1.63 = \$0.7055. If the Australian dollar sells for less than this, the appropriate arbitrage activity would be to buy the Australian dollar and exchange it for another currency. 4. Differences in trading fees and taxes may make a situation profitable for one person, but not for another. For instance, a trade in the tax-exempt account of an endowment fund may be much less attractive from the perspective of a taxable investor. 5. The law of one price states that equivalent assets should sell for the same price. You should be able to buy just as much with a twenty dollar bill as with two tens. 6. You can create a synthetic put by selling stock short and adding a long call position. The profit and loss diagram is similar to that of a put option. More formally, from put/call parity, P = C + K/(1+R) t – S.

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