Some diversification benefits from holding the two

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You own a portfolio with only two securities in it: Their tickers are JOA and MON. JOA and MON are in the same industry—but sell slightly different products, so that you get some diversification benefits from holding the two (specifically, the correlation between JOA and MON is 0.4). The portfolio is equally weighted between JOA and MON. This industry has recently been hit with bad news, but you believe that the market has over- reacted to this news and pushed the prices of all firms down too much— including JOA and MON. As a consequence of your beliefs, you have purchased call options on JOA and MON. The parameters of these call options for both stocks are: JOA MON Stock price 35 35 Strike price 40 40 Volatility 35% 40% Riskless rate (annual) 2% 2% Time to expiration 0.5 years 0.5 years a) Value the call options on JOA and MON. b) A financial institution offers to sell you a call option on your portfolio. On a per-share basis, the call option would sell for the average of the call option prices that you calculated in a), and would have a per share strike price of 40. This call would also have a six-month expiration. This strategy is offered as a substitute for buying individual call options on JOA and MON. Should you choose this alternative? Show your work.

Reference no: EM131815449

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