Vulture Corporation Ltd.’s share price is currently $8 but will either be $7 or $10.50 in a year. A risk-free Treasury bill with a 3% effective yield matures in a year. Consider a European put option on Vulture Corporation’s stock that expires in a year with an exercise price of $12.

(a) Using this context, explain what a put option is. 

(b) Construct a portfolio (i.e., some combination of put and risk-free asset) that replicates the future payoff of the stock in each state. Explain clearly what you would do today and compute the portfolio payoff in each future state. 

(c) Calculate the value today of the put option. 

(d) Suppose the put option is currently trading at $3. Describe a strategy in which you can make a riskless profit today with no net future obligations. Calculate that profit and explain clearly what you would do today and in a year. 

(e) Suppose that Vulture Corporation Ltd.’s share price will either be $5 or $15 in a year instead. How will this affect the value of the put option relative to what you calculated in part(c)? 

No calculations are required.

 

Answer rating: 100% (QA)

a A put option gives the owner the right but not the obligation to ... View the full answer