n Financial Derivatives:

a) Carefully explain why put-call parity (for options on a non-dividend paying stock) holds, which in the usual notation is: S + P = C +K exp(-rT). (You may use a table in your answer).

b) A long strangle has a payoff profile at maturity (T) of {-1, 0, +1}, which is a bucket shape. Show how you can construct a long strangle using call and put options (on the same underlying asset, with the same time to maturity). Calculate the profit for the long strangle (at T) when C=5, P=3, Kp =90 (put) and Kc=105 (call) by filling in the entries in the following table.

ST < Kp; Kc >ST > Kp; ST > Kc

Put

Call

Option Premiums

Profit =

Explain how the outcomes for the stock price at maturity ST, result in positive profits for the long strangle. At maturity, when does the long strangle lose you money?

(15 marks)