3. Financial Engineering

The stock of Klaatu Inc. is currently trading atS0dollars per share. AssumingK1< 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(K1S6)

K1S6K2

0

K2

K2S6

K3

S6K4

K4

0

K5< S6

3(K5S6)

In addition, make the following assumptions:

K3=1(K2+K4)

6-month European calls and puts are available with strike pricesK1andK5

only 6-month European puts are available with strike pricesK2,K3, andK4,S0= Present value ofK5.

(a) (5 points) Construct a final payoff diagram for this strategy.

(b) (5 points) Identify the relevant options needed to make the portfolio. Indicate the position taken in each option.