Question
Question 3 (13 marks) i) Suppose that there are three European Call options with same maturity on the same underlying asset. The underlying asset will
Question 3 (13 marks)
i) Suppose that there are three European Call options with same maturity on the same underlying asset. The underlying asset will have a spot price of at maturity. The call option prices are 1, 2 & 3, and strike prices are 1, 2 & 3. Also, suppose that the strike prices have the following relationship: 1 < 2 < 3 and 3 2 = 2 1. Construct a portfolio with the three call options, and show that
2 0.5(1 + 3)
(8 marks) Hint: the key to solve this problem is that you must construct a portfolio with the above three call options, and do some scenario analysis (i.e., compare strike prices with the spot price and work out the portfolio value at maturity). The no-arbitrage pricing condition also
applies.
ii) Using the result in part (i) and put-call parity, show that 2 0.5(1 + 3)
In this case, 1, 2 & 3 are option prices for three European Put options with strike prices 1, 2 & 3. Note that 1, 2 & 3 follow the same relationship as given in the part (i)
(5 marks)
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started