DERIVATIVE SECURITIES: PRACTICE SET 2

Suppose the investment bank A wants to purchase 100,000 shares of company XYZ from the investment bank B. The last recorded transaction in the scrip XYZ was at 2:17pm and the transaction price was Rs 155/share. Time right now is 3:00pm. That is, the stock exchange has been closed for half an hour.

Question 1

However, three month European option rates are available as the option market closes at 3:30pm. The call option on XYZ expiring 3 months from now with a strike price of Rs 145 is available for Rs. 25 whereas the put option is available for Rs. 6. The risk free interest rate is 5.07% per 3 months. Bank A argues that this transaction should be carried out at Rs 155 which is the closing price of XYZ. As a research associate working for Bank B, what would you recommend? Explain

Definition:

Question 2

Covered Call: An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset

What is the advantage of using the ‘covered call’ strategy over just writing a call option? Use payoff diagrams for both strategies to explain your answer.

Definition:

Question 3

Straddle : An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date. Make the payoff diagram for the ‘Straddle’ strategy? When will an investor adopt this strategy? What is the potential downside of this strategy? (Remember: In life as well as in finance, there is no such thing as a free lunch!)

Imagine that you are an investor who has decided to go short in a call option (i.e. writing a call)? The payoff diagram of the short call is as follows:

Question 4:

At plain sight, the payoff profile of the shorting a call doesn’t look very impressive. Nevertheless, you still go short in the call. Why would you or any other investor go short in a call (assuming there are no other positions in calls and puts)?

ECON 261 Principles of Finance Derivative Securities