Problem 3: Let C(S,K,T) denote the value of a call option with strike K and maturity...

 

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Problem 3: Let C(S,K,T) denote the value of a call option with strike K and maturity K. Assume that S<K. The "mid-point rule" was an approximation commonly used by floor traders "before the internet", to make markets for options based on information on other options with nearby strikes. It states that if K* = 2S-K, (or, equivalently, S=(K* + K)/2), then C(S, K,T) = C(S,K*,T)-(K-K*) Hint: Draw a graph of the payoff of a long call spread with strikes K and K and the curve that represents the value of the spread as a function of S. Problem 3: Let C(S,K,T) denote the value of a call option with strike K and maturity K. Assume that S<K. The "mid-point rule" was an approximation commonly used by floor traders "before the internet", to make markets for options based on information on other options with nearby strikes. It states that if K* = 2S-K, (or, equivalently, S=(K* + K)/2), then C(S, K,T) = C(S,K*,T)-(K-K*) Hint: Draw a graph of the payoff of a long call spread with strikes K and K and the curve that represents the value of the spread as a function of S.

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