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MGTC71-T2-1A

# MGTC71-T2-1A - UNIVERSITY OF TORONTO AT SCARBOROUGH...

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UNIVERSITY OF TORONTO AT SCARBOROUGH DEPARTMENT OF MANAGEMENT MGTC71: Introduction to Derivatives Markets Test-2 Supplement Questions (Option Basics + Option Strategy)

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Problem-1 [10 Points]: Answer the following short questions. a) [5 Points] Use a graph to explain why – in the absence of dividend – an American put option might be early exercised while an American call might not. Solution: Call: The lower bound is a S-PV(K) which is higher than S-K therefore the time value is always positive => It is always better to sell the American call then to exercise it. Call: Put: The lower bound is a PV(K)-S which is lower than K-S therefore the time value can be negative => The deep in the money put options will be exercised – have negative time value. 2 PV(K) K PV(K) K
b) [5 Points] Create and graph a portfolio of puts and calls that replicate a forward contract. Use this portfolio to find the value of a forward contract. Solution: ) ( ) ( K PV S P C K PV C S P - = - + = + 0 T Long C 0 ST-K Short P -(K-ST) 0 Payoff (Forward) ST-K ST-K The value of forward contract is S(0)-PV(k): 3 K

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