Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

Your brother-in-law has been reading too many get rich quick articles and wants to try his hand at investing in derivatives. He has turned to

Your brother-in-law has been reading too many get rich quick articles and wants to try his hand at investing in derivatives. He has turned to you, the business school all-star, for advice on valuing and exercising stock options. Currently he is tracking a particular stock and has noticed that the price fluctuates quite a lot even though it doesnt change that much in the long run. He feels that if he buys call options on the stock, he can profit from this volatility with minimal risk and investment on his part. Since you have studied finance, you know that a call option is a contract that gives you the right to purchase a share of a specified stock at some future date, at a pre-determined price (the strike price). If you exercise the option (meaning: buy the shares), it is assumed that you immediately re-sell the shares at the prevailing market price and pocket any gains. If the market price is below the strike price when the option expires, obviously you would not exercise the option, and anything you paid for the option contract will be lost. Your brother has asked you to help him determine how much he should be willing to pay for such an option, on a per share basis. You explain that the value of the option to him depends entirely on his assumptions about the stock price movements over time. He replies that the stock is currently trading at $100/share, and while he doesnt expect any long-term change, over the course of an average month he expects the price to either go up or down by $15, with equal probability. He can buy a 90-day (three-month) call option with a strike price of $110. Model this as a European call option, purchased on Nov. 1. A European call can only be exercised on a specific date three months from now: the end of January. Also, model the stock price movements to take place once per month. What is the value of this option to your brother-in-law, per share? (Show your work.)

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Corporate Finance Principles And Practice

Authors: Denzil Watson, Tony Head

1st Edition

0273630083, 978-0273630081

More Books

Students also viewed these Finance questions

Question

How did the authors address the fallacy of homogeneity?

Answered: 1 week ago

Question

Why is forecasting important?

Answered: 1 week ago