You hold a bearish view about a stock in your portfolio. To hedge the downside risk,...

     

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You hold a bearish view about a stock in your portfolio. To hedge the downside risk, your investment bank proposes you a power option that pays (max{K - ST, 0}) at maturity, where S, is the stock price at its maturity date and K is the strike price. The stock price is currently $30. During each two-month period for the next four months it is expected to increase by 8% or reduce by 10%. The risk-free interest rate with continuous compounding is 5% per annum. a) b) c) Explain why a power option is more levered than a standard put option with the same parameters. arks) Use a two-period binomial tree to calculate the value of a power option with K=$30 and maturity date in 4 months. Plot the tree and specify the value of the option at each node. ( narks) If the option in b) is American style, should it be exercised early? What is the price of the American-style option? arks) (Total: marks) You hold a bearish view about a stock in your portfolio. To hedge the downside risk, your investment bank proposes you a power option that pays (max{K - ST, 0}) at maturity, where S, is the stock price at its maturity date and K is the strike price. The stock price is currently $30. During each two-month period for the next four months it is expected to increase by 8% or reduce by 10%. The risk-free interest rate with continuous compounding is 5% per annum. a) b) c) Explain why a power option is more levered than a standard put option with the same parameters. arks) Use a two-period binomial tree to calculate the value of a power option with K=$30 and maturity date in 4 months. Plot the tree and specify the value of the option at each node. ( narks) If the option in b) is American style, should it be exercised early? What is the price of the American-style option? arks) (Total: marks)

Answer rating: 100% (QA)

Power Option Leverage vs Standard Put a A power option offers higher leverage compared to a standard put option with the same parameters strike price and maturity due to the squared term in its payoff ... View the full answer