(Creation of payoffs using options) Consider the following three call options on a non- dividend-paying stock...

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(Creation of payoffs using options) Consider the following three call options on a non- dividend-paying stock expiring in T: Strike K1-$17/share K2=$20/share K3=$23/share Premium $5.00/share $3.00/share $2.00/share Assume that one option contract corresponds to 100 shares of stock. You want to create the following payoff: • If S(T)<K1, payoff (time 0 cash flow + time T cash flow) = +$100; • If S(T)>K3, payoff (time 0 cash flow + time T cash flow) = +$100. In other words, you want to receive a fixed payoff of +$100 if S(T) is sufficiently away from K2. (Following usual conventions, the time-value of money is ignored in the payoff calculation.) How will you create such payoff by trading the call options given in the above? Explain your strategy by drawing a payoff diagram (Creation of payoffs using options) Consider the following three call options on a non- dividend-paying stock expiring in T: Strike K1-$17/share K2=$20/share K3=$23/share Premium $5.00/share $3.00/share $2.00/share Assume that one option contract corresponds to 100 shares of stock. You want to create the following payoff: • If S(T)<K1, payoff (time 0 cash flow + time T cash flow) = +$100; • If S(T)>K3, payoff (time 0 cash flow + time T cash flow) = +$100. In other words, you want to receive a fixed payoff of +$100 if S(T) is sufficiently away from K2. (Following usual conventions, the time-value of money is ignored in the payoff calculation.) How will you create such payoff by trading the call options given in the above? Explain your strategy by drawing a payoff diagram

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To create the desired payoff we can construct a combination of call options to effectively create a payoff profile that matches the given conditions G... View the full answer