Question

I need the correct solution with all steps:

Consider the following strategy on May 14 involving June 18 options:

Buy the 125 call at $13.50,

Buy the 130 put at $14.50,

Sell the 130 call at $11.35, and

Sell the 125 put at $ 11.50.

If the risk-free rate is 4.56% per year and the time remaining to expiration is 0.0959 years, should the investor execute the position? What is the net present value of the trade?

Answer 1

Here,

We can create synthetic long stock and short stock..

In synthetic long stock,.

Buy call options and sell put options of same stocks.

If price remains same at the time of exercising in respect to exercise price.

No profit no loss would be there.

If price increases, we can make profit by exercising call options  

If price drops, we can make loss because of put option would be exercised.

Now, synthetic short stock.

Buy put options and sell call options .

Same here, if price does not move, no profit no gain.

If price decrease, we can make profit by exercising put options.

If price increases , we can make loss because of call options would be exercised.

Now come to the point,

If market price of stocks increase, we can execute synthetic long stock. Can make profit by exercising call options.

If market price drops, we can execute synthetic short stock. Can make profit by exercising put options.

In this trade,  

Outflow would be= 1350+1450=2800 dollars.

Inflow would be =1135+1150=2285 dollars .

Trade value would be = outflow - inflow + interest  

=2800-2285=515+2.252116=517.2521

Total trade value = 517.2521 dollars..

Thanks.

If you require more clarity, write back to me..