Assignment: Fin 550: 7- Suppose the current value of a popular stock index is 653.50 and the dividend yield on the index is 2.8%. Also, the yield curve is flat at a continuously compounded rate of 5.5%. a. If you estimate the volatility factor for the index to be 16%, calculate the value of an index call option with an exercise price of 670 and an expiration date in exactly three months. c. Besides volatility estimation error, explain why your valuation and the option’s traded price might differ from one another. 10- Melissa Simmons is the chief investment officer of a hedge fund specializing in options trading. She is currently back testing various option trading strategies that will allow her to profit from large fluctuations-either up or down-in a stock’s price. An example of such typical trading strategy is straddle strategy that involves the combination of a long call and a long put with an identical strike price and time to maturity. She is considering the following pricing information on securities associated with friend work, a new internet start-up hosting a leading online social network: -Friend work stock: $100 – Call option with an exercise price of $100 expiring in one year: $9 Put option with an exercise price of $100 expiring in one year: $8 a. Use the above information on friend work and draw a diagram showing the net profit/loss position at maturity for the straddle strategy. Clearly label on the graph the break-even points of the position. b. Melissa’s colleague proposes another lower-cost option strategy that would profit from a large fluctuation in friend work’s stock price: Long call option with an exercise price of $110 expiring in one year: $6 Long put option with an exercise price of $90 expiring in one year: $5 Similar to part a, draw a diagram showing the net profit/loss position for the above alternative option strategy. Clearly label on the graph the breakeven points of the position.
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