4. Financial Options

(a) Draw the payoff of each of the following portfolios in a diagram where the horizontalaxis is the share price of ABC and the vertical axis is the payoff. (Note: Do NOTinclude the price of the options). Explain how you determined the payoffs.

Portfolio 1: Buying one put option and one call option on ABC, both with strike price$40 and expiration next period.

Portfolio 2: Buying one share of ABC, one put option with strike price $20, and sellinga call option on one share of ABC with strike price $40 and expiration next period.

(b) Suppose the current price of Company ABC is $40, and the company is facing a decisionin a lawsuit. Depending on whether the decision is favorable or not, the price of ABCis likely to either increase or fall by a lot. Which of the portfolios from part (a) is likelyto be the best investment in these circumstances, and why?