Your company, Diamonds, Inc, owns a stock of diamonds which you would like to sell next year. The value of your diamonds next year depends on consumer demand, which is determined by the state of the economy (recession or boom). There are two tradedfinancial assets in this economy, a stock index and a Treasury following economic data:

 

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State 1: Boom State 2: Recession Price today Value of your diamonds Stock index Treasury bond 14 10 8 10 10 9 10 4 (a) Assume LOOP holds. At what price could you sell your diamonds today? (b) What is the price of a European call option on the stock index that has a strike price of 4 and expires next year? (c) What is the price of a European put option with the same strike price and expi- ration? Explain your answer. (d) Downhill, an investment management company is selling call options on the stock index with strike $11 expiring next year, for a price of $1.20. Can you make money? What is your arbitrage trade? What do you expect Downhill to do? State 1: Boom State 2: Recession Price today Value of your diamonds Stock index Treasury bond 14 10 8 10 10 9 10 4 (a) Assume LOOP holds. At what price could you sell your diamonds today? (b) What is the price of a European call option on the stock index that has a strike price of 4 and expires next year? (c) What is the price of a European put option with the same strike price and expi- ration? Explain your answer. (d) Downhill, an investment management company is selling call options on the stock index with strike $11 expiring next year, for a price of $1.20. Can you make money? What is your arbitrage trade? What do you expect Downhill to do?