Iconic British brand Promitte manufactures a yeast-based sandwich paste, sold all over the world. A key...

 

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Iconic British brand Promitte manufactures a yeast-based sandwich paste, sold all over the world. A key ingredient of the product is schlopp, which the British firm imports from Europe. With Britain's impending departure from the European Union (Brexit), Promitte is concerned the price of schlopp could rise even though its supply is expected to rise sharply, and far exceed demand. As a result of its concerns, Promitte is considering entering into an option contract. Your financial modelling team have studied the price of schlopp and have come to the conclusion that over the next three months the price of schlopp may rise by 20% if there is a 'hard' Brexit (occurring with probability p) or fall by 16.6667% (= 1-1/1.2, occurring with probability 1-p) if there is a 'soft' Brexit. The current price per metric tonne of schlopp is £50. Promitte can borrow money today for any period under six months at the rate of J12 = 5% p.a. a. [2 marks] What type of option contract would Promitte buy to give it the right to buy schlopp in three month's time at a price of £50 per metric tonne? Draw a cash flow diagram setting out the cash flows of such an option contract. (Quote prices to five decimal places.) b. [4 marks] Consider the replicating portfolio (i.e., the investment strat- egy which will give identical payoffs, at the end of three months, to the option contract), that involves buying h metric tonnes of schlopp today, and borrowing $B for three months. Find the values of h and B. c. [1 mark] What is the initial cost (net outlay) today of investing in the replicating portfolio? Round your answer to three decimal places. d. [2 marks] What is the fair price (premium) for the option contract? Why? Round your answer to three decimal places. Iconic British brand Promitte manufactures a yeast-based sandwich paste, sold all over the world. A key ingredient of the product is schlopp, which the British firm imports from Europe. With Britain's impending departure from the European Union (Brexit), Promitte is concerned the price of schlopp could rise even though its supply is expected to rise sharply, and far exceed demand. As a result of its concerns, Promitte is considering entering into an option contract. Your financial modelling team have studied the price of schlopp and have come to the conclusion that over the next three months the price of schlopp may rise by 20% if there is a 'hard' Brexit (occurring with probability p) or fall by 16.6667% (= 1-1/1.2, occurring with probability 1-p) if there is a 'soft' Brexit. The current price per metric tonne of schlopp is £50. Promitte can borrow money today for any period under six months at the rate of J12 = 5% p.a. a. [2 marks] What type of option contract would Promitte buy to give it the right to buy schlopp in three month's time at a price of £50 per metric tonne? Draw a cash flow diagram setting out the cash flows of such an option contract. (Quote prices to five decimal places.) b. [4 marks] Consider the replicating portfolio (i.e., the investment strat- egy which will give identical payoffs, at the end of three months, to the option contract), that involves buying h metric tonnes of schlopp today, and borrowing $B for three months. Find the values of h and B. c. [1 mark] What is the initial cost (net outlay) today of investing in the replicating portfolio? Round your answer to three decimal places. d. [2 marks] What is the fair price (premium) for the option contract? Why? Round your answer to three decimal places.

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a Promitte would buy a call option with a strike price of 250 per metric tonne The cash flows of suc... View the full answer