Today is t= 0. Derivative Y is a combination of a 1-year European long call and...

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Today is t= 0. Derivative Y is a combination of a 1-year European long call and 1-year European long put, both with strike prices of $100. The payout of the derivative is thus max(S₁-100, 100-S₁) at t = 1. The 1-year risk free rate (with continuous compounding) is 10%. The current stock price at t = 0 is 130. The stock will pay out a dividend of $0.20 at t = 0.5. You can buy Derivative Y at a price of $29.50. Hint: this question is in the same spirit as the problem we considered where the price of an in-the- money call option was equal to S - K prior to maturity. a) Describe how you can construct an arbitrage. Part of your strategy will involve buying Derivative Y. Describe all other trades. Your strategy should have a zero net cash flow at t = 0 and a guaranteed positive cash flow at t = 1 (but the amount of profit at t = 1 can vary depending on the final stock price at t=1). b) What is your profit at t = 1 if the stock price =1100? c) What is your profit at t = 1 if the stock price = 120? d) What is your profit at t = 1 if the stock price is 90? Today is t= 0. Derivative Y is a combination of a 1-year European long call and 1-year European long put, both with strike prices of $100. The payout of the derivative is thus max(S₁-100, 100-S₁) at t = 1. The 1-year risk free rate (with continuous compounding) is 10%. The current stock price at t = 0 is 130. The stock will pay out a dividend of $0.20 at t = 0.5. You can buy Derivative Y at a price of $29.50. Hint: this question is in the same spirit as the problem we considered where the price of an in-the- money call option was equal to S - K prior to maturity. a) Describe how you can construct an arbitrage. Part of your strategy will involve buying Derivative Y. Describe all other trades. Your strategy should have a zero net cash flow at t = 0 and a guaranteed positive cash flow at t = 1 (but the amount of profit at t = 1 can vary depending on the final stock price at t=1). b) What is your profit at t = 1 if the stock price =1100? c) What is your profit at t = 1 if the stock price = 120? d) What is your profit at t = 1 if the stock price is 90?

Answer rating: 100% (QA)

a To construct an arbitrage we need to ensure a zero net cash flow at time t0 and a guaranteed posit... View the full answer