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CHAPTER 20

# Therefore thisisequivalentto

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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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