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Unformatted text preview: and the righthand side [7 + 50 = 57] are essentially equal, so there is no mispricing. For the first sixmonth option, the lefthand side [17 + (40/1.05) = 55.10] is slightly greater
than the righthand side [5 + 50 = 55], so there is a slight mispricing. For the second sixmonth option, the lefthand side [10 + (50/1.05) = 57.62] is slightly less
than the righthand side [8 + 50 = 58], and so there is a slight mispricing. 21. The value of the options increases if the variance of the cash flows increases. Therefore,
you will prefer the riskier proposal. 22. One strategy might be to buy straddle, that is, buy a call and a put with exercise price
equal to the asset’s current price. If the asset price does not change, both options
become worthless. However, if the price falls, the put will be valuable and, if price rises,
the call will be valuable. The larger the price movement in either direction, the greater the
profit. If investor’s have underestimated volatility, the option prices will be too low. Thus, an
alternative strategy is to buy a call (or a put) and hedge against changes in the asset price
by simultaneously selling (or, in the case of the put, buying) delta shares of stock.
Challenge Questions 1. Letter the diagrams in Figure 20.13 (a) through (d), beginning in the upperleft corner and
proceeding clockwise. Then we have the following diagram interpretations: a. Purchase a call with a given exercise price and sell a call with a higher exercise
price; borrow the difference necessary. (This is known as a ‘Bull Spread.’) b. Sell a put and sell...
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This note was uploaded on 04/26/2013 for the course MATH 289Q taught by Professor Jamesbridgeman during the Fall '04 term at UConn.
- Fall '04