(a) Holding all other factors constant, fully explain how changing the ‘Time to maturity’ affects: 

• The price of a European call option. 
• The price of a European put option.

(b) The stock of MI Ltd. currently trades at $63.50 and the company is committed to paying dividends of $5 in 3 months and 9 months from now. A 6-month European put contract written on the stock, with a strike price of $65, is trading at $7.15. The risk-free rate is 5% per annum with continuous compounding for all maturities. What is the price of a European call written on the same stock, with the same strike price and same time to maturity? 

(c) The Bank of Torlone has issued a 5-year loan of €50 million to a large corporate client, IOK Inc. The bank owners are now concerned that IOK’s financial position may be deteriorating and they wish to hedge the credit risk. Write a report for the owners of Bank of Torlone advising them how they can hedge this risk. Give details of the proposed hedging instrument and providing numerical examples of what the cash flows associated with this strategy would be if 

• IOK never defaults;  
• IOK default after 3.25 years. 

Answer rating: 100% (QA)

The price of a European call option will increase as the time to maturity increases This is because the call option will have more time to appreciate in value if it is held until expiration The longer ... View the full answer