How you would exploit the resulting arbitrage opportunity

Reference no: EM133583647

Problem

Question I. ABC stock is currently at 100. In the next period, the price will either increase by 10% or decrease by 10%. The risk-free rate of return per period is 2%. Consider a call option on ABC stock with strike K = 100.

1. Set up a replicating portfolio to value the call.

2. Suppose the call is trading for $7. Explain how you would exploit the resulting arbitrage opportunity.

Question II. ABC stock is currently at 100. In the next period, the price will either increase by 5% or decrease by 5%. The risk-free rate of return per period is 3%. Consider a put option on ABC stock with strike K = 100.

1. Set up a replicating portfolio to value the put.

2. Suppose the put is trading for $2. Explain how you would exploit the resulting arbitrage opportunity.

Question III. Portfolio insurance: The current price of the stock we are holding is $100. We want to continue to hold the stock position but modify it so that the portfolio value never drops below $90. If the stock may move up to $130 or down to $80 after one period, how do we modify our holding of $100 so as to make sure that it is at least of $90 value at the end of the period? The rate of simple interest for the period is 10%.

Reference no: EM133583647

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