Part I.

Suppose you subscribe to a service that gives you estimates of the theoretically correct volatility of stocks. You note that the implied volatility of a particular option is substantially higher than the theoretical volatility. What action should you take and why?

Part II.

Explain how to use call options and put options to create a synthetic short position in stock.

Part III.

Consider two investors who agree on the stock's price and volatility but who do not agree on the stock's expected return. One believes that the stock price will earn 15 percent over the next year, while the second believes that it will have a negative 5 percent return. Will they agree or disagree on the value of a one-year call option on the stock when using the Black-Scholes-Merton Model? Justify your answer. [Please note, by answering only "agree" or "disagree" without reasoning, a zero mark will be awarded.]