APU Financial issues a market-linked CD that guarantees the original principal with an interest at an...

 

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APU Financial issues a market-linked CD that guarantees the original principal with an interest at an effective annual rate of 2.5%, plus 60% of the percentage gain on the MAC Inc. non- dividend-paying stock price over a two-year period. At the time the CD is issued, a share of MAC Inc. is worth $120, and the risk-free annual interest rate is 5%. (a) UPA Financial issues a similar CD that guarantees the original principal plus 75% of the percentage increase in the MAC Inc. stock price. Determine the stock price at the end of two years so that the payoffs of the two CD's are equal. (b) Currently, the premium of an at-the-money put option on a share of MAC Inc. is $5. (i) Show that an arbitrage opportunity exists from the CD offered by APU Financial. (ii) Explain your strategy to exploit the arbitrage opportunity. APU Financial issues a market-linked CD that guarantees the original principal with an interest at an effective annual rate of 2.5%, plus 60% of the percentage gain on the MAC Inc. non- dividend-paying stock price over a two-year period. At the time the CD is issued, a share of MAC Inc. is worth $120, and the risk-free annual interest rate is 5%. (a) UPA Financial issues a similar CD that guarantees the original principal plus 75% of the percentage increase in the MAC Inc. stock price. Determine the stock price at the end of two years so that the payoffs of the two CD's are equal. (b) Currently, the premium of an at-the-money put option on a share of MAC Inc. is $5. (i) Show that an arbitrage opportunity exists from the CD offered by APU Financial. (ii) Explain your strategy to exploit the arbitrage opportunity.

Answer rating: 100% (QA)

a The price of MAC Inc stock would need to be 180 at the end of two years for the two CDs to ... View the full answer