Consider the prices of following American call options with different maturities and strike prices. Assume the...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
Consider the prices of following American call options with different maturities and strike prices. Assume the current stock price is $30 and no dividends will be paid prior to the July expiration date. The risk-free interest rate is 5% and it is expected to remain constant over the next 2 years. It is currently 3-month away from the maturity date of January call options. Strike price 20 25 35 January 10.25 4.90 0.26 April 10.50 5.90 0.77 July 10.77 7.85 1.28 1) Find three mispricings, explain what arbitrage restriction on call prices is being violated. For each of them, explain how you could take advantage of these mispricings and numerically illustrate how your designed strategy leads to an arbitrage profit(s). (10 marks) ii) What further information would you need to know if you would like to pin down the source of the mispricing? Explain why you do not need this information in identifying the arbitrage opportunities in i). (3 marks) b) Company ABC plans to issue a new class of shares, class X, which is different from its common stock. The class X shares can have a pre-set dividend schedule and the holders of the class X shares must be paid any promised but unpaid dividends before any common shareholders receive dividends. This class X shares come with a mandatory redemption at a predetermined time with a value equals to that of one unit of common share but up to a dollar value capped at some predetermined price (i.e. the value of one unit of the class X share is capped at this predetermined price after redemption). Suppose ABC's common stock is currently traded at $40 per share and has an annualized volatility of 0.20. The risk-free rate is 6% per annum. 1) Suppose neither the common stock nor the Class X stock pays a dividend. The mandatory redemption is in three years time and the value is capped at $60 per share. Give you best estimate of the current per share price of this Class X stock? (4 marks) ii) Suppose that Company ABC's common stock pays no dividend but the Class X share will pay one dividend in 2 years time. If the firm wants to sell the Class X at par of $40 per share, what does the dividend have to be? Explain your working. (3 marks) Consider the prices of following American call options with different maturities and strike prices. Assume the current stock price is $30 and no dividends will be paid prior to the July expiration date. The risk-free interest rate is 5% and it is expected to remain constant over the next 2 years. It is currently 3-month away from the maturity date of January call options. Strike price 20 25 35 January 10.25 4.90 0.26 April 10.50 5.90 0.77 July 10.77 7.85 1.28 1) Find three mispricings, explain what arbitrage restriction on call prices is being violated. For each of them, explain how you could take advantage of these mispricings and numerically illustrate how your designed strategy leads to an arbitrage profit(s). (10 marks) ii) What further information would you need to know if you would like to pin down the source of the mispricing? Explain why you do not need this information in identifying the arbitrage opportunities in i). (3 marks) b) Company ABC plans to issue a new class of shares, class X, which is different from its common stock. The class X shares can have a pre-set dividend schedule and the holders of the class X shares must be paid any promised but unpaid dividends before any common shareholders receive dividends. This class X shares come with a mandatory redemption at a predetermined time with a value equals to that of one unit of common share but up to a dollar value capped at some predetermined price (i.e. the value of one unit of the class X share is capped at this predetermined price after redemption). Suppose ABC's common stock is currently traded at $40 per share and has an annualized volatility of 0.20. The risk-free rate is 6% per annum. 1) Suppose neither the common stock nor the Class X stock pays a dividend. The mandatory redemption is in three years time and the value is capped at $60 per share. Give you best estimate of the current per share price of this Class X stock? (4 marks) ii) Suppose that Company ABC's common stock pays no dividend but the Class X share will pay one dividend in 2 years time. If the firm wants to sell the Class X at par of $40 per share, what does the dividend have to be? Explain your working. (3 marks)
Expert Answer:
Answer rating: 100% (QA)
Here are my responses a 1 One mispricing is the January 20 call price of 1025 Using putcall parity w... View the full answer
Related Book For
Fundamentals of Financial Management
ISBN: 978-0324597707
12th edition
Authors: Eugene F. Brigham, Joel F. Houston
Posted Date:
Students also viewed these finance questions
-
Managing Scope Changes Case Study Scope changes on a project can occur regardless of how well the project is planned or executed. Scope changes can be the result of something that was omitted during...
-
Read the case study "Southwest Airlines," found in Part 2 of your textbook. Review the "Guide to Case Analysis" found on pp. CA1 - CA11 of your textbook. (This guide follows the last case in the...
-
KYC's stock price can go up by 15 percent every year, or down by 10 percent. Both outcomes are equally likely. The risk free rate is 5 percent, and the current stock price of KYC is 100. (a) Price a...
-
On 28 April 2020, Mr Guna, CEO of Econ Engineering Malaysia, proposed to complete an abandoned boiler project that no one had dared to revive. He knew that the project was 60% complete before it was...
-
If interest rates are expected to increase, should investors look to long-term bonds or short-term securities? Explain.
-
PepsiCos financial statements are presented in Appendix A. Financial statements for The Coca-Cola Company are presented in Appendix B. Instructions Based on information contained in these fi nancial...
-
A company wishes to hedge its exposure to a new fuel whose price changes have a 0.6 correlation with gasoline futures price changes. The company will lose $1 million for each 1 cent increase in the...
-
The completed financial statement columns of the worksheet for Bray Company are shown as follows. Instructions (a) Prepare an income statement, an owners equity statement, and a classified balance...
-
2. 2. A 20 kg child climbs to the top of a slide that is 3 m above the ground level. She starts from rest and slides down the incline. a. Define and model the energy of the system with Energy Bar...
-
Complete Form 941 for the 4th quarter for TCLH Industries (which is located at 202 Whitmore Avenue, Durham, NC 27701; Employer Identification #44-4444444). Assume that all necessary deposits were...
-
A red and a yellow rock collide on frictionless ice. Before the collision, the 15.000 kg red rock is travelling at 10.00 m/s [E] and the 10.000 kg yellow rock is travelling at 85.000 m/s [W 10 N]....
-
Estimated direct labor hours Allocated manufacturing overhead Estimated manufacturing overhead costs Actual manufacturing overhead costs By how much is manufacturing overhead over or underallocated?...
-
A square coil of wire containing a single turn is placed in a uniform 0.25 T magnetic field, as the drawing shows. Each side has a length of 0.32 m, and the current in the coil is 12 A. The direction...
-
A student is measuring the wavelength of a narrow, monochromatic light source. The double slit has a separation of 0.15 mm. A second student places markers on a screen 2.0 m in front of the slits at...
-
While you are running down the street you give off 4.7x10 4 joules of heat and you do 6.8x10 4 J of work. What is your change in internal energy?
-
A car is travelling with a velocity of 17 m/s on a straight horizontal highway. The wheels of the car has a radius of 48.0 cm. If the car then speeds up with an acceleration of 2 m/s for 5 s,...
-
Question. 30v t=0 far Xt=1 ww (602, i(t) www 3402 IMF 25 H For the following network determine ((+), 120 Switch is opened at t=0.
-
Feller Company purchased a site for a limestone quarry for $100,000 on January 2, 2019. It estimate that the quarry will yield 400,000 tons of limestone. It estimates that its retirement obligation...
-
The real risk-free rate is 3%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities?...
-
Robert Balik and Carol Kiefer are senior vice presidents of the Mutual of Chicago Insurance Company. They are codirectors of the companys pension fund management division, with Balik having...
-
The Zinn Company plans to issue $20,000,000 of 10-year bonds in December to help finance a new research and development laboratory. It is now August, and the current cost of debt to the high-risk...
-
Cress Trust owns houses in Marion County, for whom Rainbow Realty Group, Inc., sells, rents, and manages. The same person serves as Rainbows president and Cresss corporate trustee. Cress offers four...
-
Genevieve and William Timmons began their tenancy of a ground-floor apartment at Cobblestone Square in September 2011. Kingsley-Johnston, Inc., is a property management company responsible for...
-
Linda Miller rented 35 acres of pastureland in Wabaunsee County, Kansas, from William Burnett for $1,000 per year. Miller and her husband used the land to grow and harvest brome grass for their...
Study smarter with the SolutionInn App