Question 5 (Derivatives Securities-Calculation and theory)

Part A

You happened to check the newspaper and noticed an arbitrage opportunity. The current stock

price of Kevin Ltd is $20 and the one-year risk free rate is 8%. A one year put option on Kevin Ltd with a strike price of $18 sell for $3.33, while the identical call sell for $7. What is your arbitrage profit if you take advantage of the opportunity available to you?

Part B

You own a put option on Ford stock with a strike price of $30. You paid $3 for the call option

which will expire in exactly six months' time.

a. If the stock is trading at $38 in six months' time, what will be the pay out of the put?

b. If the stock is trading at $38 in six months' time, what will be the profit or loss of the put?

c. If the stock is trading at $29 in six months' time, what will be the pay out of the put?

d. If the stock is trading at $29 in six months' time, what will be the profit or loss of the put?

e. Illustrate using a payoff diagram showing the value of the call at expiration for (a) as a

function of the stock price at expiration.