3. (a) Explain the similarities and differences between being the short party of a forward contract...

     

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3. (a) Explain the similarities and differences between being the short party of a forward contract and being the holder of an American put option contract. [6 marks] Suppose St is the price of a company's share at time t. Let at time t, ct be the price of a European call option contract and pt be the price of a European put option contract on the share with the same strike price K and maturity date T. The continuously compounded constant risk-free rate of interest is r per annum. Consider two times u and v such that t < u <v < T. Let a single dividend payment of D per share is to be paid at time u and a single custodian fee of E per share has to be paid at time v. (A custodian is a financial institution that holds customers' shares for safekeeping to prevent them from being stolen or lost.) (b) Show that: ct + Ke¯r(T-t) + De¯r(u-t) = Pt+St+Ee-r(v-t). [6 marks] (c) Discuss the impact of dividend payments and custodian fees on European call and put option prices. [4 marks] [Total: 16 marks] 3. (a) Explain the similarities and differences between being the short party of a forward contract and being the holder of an American put option contract. [6 marks] Suppose St is the price of a company's share at time t. Let at time t, ct be the price of a European call option contract and pt be the price of a European put option contract on the share with the same strike price K and maturity date T. The continuously compounded constant risk-free rate of interest is r per annum. Consider two times u and v such that t < u <v < T. Let a single dividend payment of D per share is to be paid at time u and a single custodian fee of E per share has to be paid at time v. (A custodian is a financial institution that holds customers' shares for safekeeping to prevent them from being stolen or lost.) (b) Show that: ct + Ke¯r(T-t) + De¯r(u-t) = Pt+St+Ee-r(v-t). [6 marks] (c) Discuss the impact of dividend payments and custodian fees on European call and put option prices. [4 marks] [Total: 16 marks]

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Ans The present value of the contract at t0 can be calculated by discounting each cash flow back to ... View the full answer