Explain why a chooser option is less expensive than straddle

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Demonstrate that the payoffs of a chooser option with an exercise price of X and a time to expiration of T that permits the user to designate it as a call or a put at t, can be replicated with two transactions. Specifically, by (1) buying a call with an exercise price of X and time to expiration of T and (2) buying a put with an exercise price equal to X(1 þ r)-(T - t) and time to expiration of t. This proof will require that you consider two possible outcomes at t (user designates it as a call or user designates it as a put according to the rule given in this chapter). For each outcome at t, there are two possible outcomes at T, ST 2" X or ST <>X. Explain why a chooser option is less expensive than a straddle.

Reference no: EM13925759

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