College Algebra
College Algebra
1st Edition
ISBN: 9781938168383
Author: Jay Abramson
Publisher: OpenStax
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We consider the one-period model studied in class as an example. Namely, we assume
that the current stock price is S0 = 10. At time T, the stock has either moved up to
St = 12 (with probability p = 0.6) or down towards St = 8 (with probability 1−p = 0.4).
We consider a call option on this stock with maturity T and strike price K = 10. The
interest rate on the money market is zero.
As in class, we assume that you, as a customer, are willing to buy the call option on
100 shares of stock for $120. The investor, who sold you the option, can adopt one of the
following strategies:
ˆ Strategy 1: (seen in class) Buy 50 shares of stock and borrow $380.
ˆ Strategy 2: Buy 55 shares of stock and borrow $430.
ˆ Strategy 3: Buy 60 shares of stock and borrow $480.
ˆ Strategy 4: Buy 40 shares of stock and borrow $280.
(a) For each of strategies 2-4, describe the value of the investor’s portfolio at time 0,
and at time T for each possible movement of the stock.
(b) For each of strategies 2-4, does the investor have an arbitrage ? Reminder: an
arbitrage is an opportunity to obtain a positive profit without risk.
(c) If you were the investor, which strategy would you adopt and why ? (This is an
open question without a right or wrong answer. Feel free to elaborate.)

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