UNIVERSITY OF ESSEX DEPARTMENT OF ECONOMICS Session 2011–12 R. E. Bailey EC372 Economics of Bond and Derivatives Markets Exercise 5: Options Markets: I Fundamental ideas 1. Derive the lower bound for a European style call option premium: c ≥ max ±0 , S-X R ( t, T ) ² . Hint: follow the steps of the numerical example in Economics of Financial Markets , chapter 18 (section 18.4), and use symbols to replace the numbers. 2. Derive the put-call parity relationship for European style options: c + X R ( t, T ) = p + S. (1) 3. At date t it is observed that the ordinary shares of Acme Inc currently trade for $10 each. European style put options on Acme Inc shares are traded with exercise price, $165, for each share, and expiry date, T > t . The interest factor for risk-free borrowing and lending between t and T is given by R ( t, T ) = 1 . 10 . It is also known that Acme Inc will pay no dividends on its ordinary shares between t and T , and market frictions may be ignored. (a) Show that the premium,
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