2. Payoff Diagrams

The stock of Klaatu Inc. is currently trading at S0 dollars per share. Assuming K1 < K2 < K3 < K4 < K5, consider a portfolio of European put and call options which pay the following on expiration in 6 months:

Stock Price (S6) Portfolio Payoff

S6 < K1 3(K1 S6)

K1 S6 K2 0

K2

K3

K4 S6 K5 0

K5 < S6 3(K5 S6)

In addition, make the following assumptions:

K3 = 1 (K2 + K4),

6 month European calls and puts are available with strike prices K1 and K5,

only 6 month European puts are available with strike prices K2, K3, and K4,

S0 = Present value of K5.

Answer the following:

1. (a)Construct a final payoff diagram for this strategy.
2. (b)Identify the relevant options needed to create this portfolio. Indicate the position taken in each option.