Black-Scholes demonstrates that the value of a put option increases the longer the time to expiration. Currently
Question:
Black-Scholes demonstrates that the value of a put option increases the longer the time to expiration. Currently the price of a stock is $100 and there are two put options to sell the stock at $100. The three-month option sells for $7.00 and the six-month option sells for $4.50.
a) What would you do and why?
b) How much do you earn or lose after three months at the following prices of the underlying stock: $85, $90, $95, $100, $105, and $110? Assume the worst-case scenario.
c) Is there any reason to anticipate earning a higher return than your answers in (b)?
Step by Step Answer:
a This problem is another illustration of a riskless arbitrage The investor should buy the call with ...View the full answer
Related Video
A put option is a financial contract that gives the owner the right, but not the obligation, to sell an underlying asset, such as a stock or a commodity, at a predetermined price, known as the strike price, on or before a specific date, known as the expiration date. Put options are used by investors as a form of insurance against a decline in the value of the underlying asset. If an investor expects the value of an asset to fall in the future, they can purchase a put option on that asset. If the value of the asset does fall, the put option will increase in value, allowing the investor to sell the asset at the higher strike price. For example, if an investor owns 100 shares of a stock that is currently trading at $50 per share, they may purchase a put option with a strike price of $45 and an expiration date three months in the future. If the stock price falls to $40 before the expiration date, the investor can exercise the put option and sell their shares for $45 each, even though the market price is only $40. This would allow the investor to limit their losses. It\'s important to note that purchasing a put option involves paying a premium to the seller of the option, and the investor can lose the entire premium if the price of the underlying asset does not decline as expected. Put options are just one type of financial derivative and should only be used by experienced investors who understand the risks involved.
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