In: Finance
Question 1
prices?
Question 2
Assume that the annual 9O-day LIBOR 30-days from now (at expiration) is 6%. Compute the cash settlement payment at expiration and identify which party makes the payment.
Question 3
the stock price can go lower. How would you resolve this apparent paradox?
Question 4
Suppose that each of two investments has a 4% chance of a loss of $10 million, a 2% chance of a loss of $1 million, and a 94% chance of a profit of $1 million. They are independent of each other.
95%?
confidence level is 95%?
investments when the confidence level is 95%?
Part 1
What would happen in the options market if the price of an American call were less than the value Max (0, S0 − X)? Would your answer differ if the option were European? Explain
First of all the below given answer by me will hold good for both Americal and European Call Option so any representation will be applicable to both the type of options.
We all know that Max (0, S0 − X) represents the Minimum price or the minimum boundary condition of the call option and also that price of any option in any circumstance cannot be negative but still what would happen if it is negative?
the price of option is the sum of intrinsic value and time value. Ignoring the time value here, any trader would definitely not exercise the option and would choose to rather abandon the option. At large, no one would sell any call option at a loss and negative pricing would also state that seller will pay the buyer for the option. It is the case of clear mismatch between demand and supply and would disbalance the entire financial derivatives market.
Part 2
In order to understand the phrase, we need to know a very simple logic behind Deep In The Money (DITM) Call Options. Generally, DITM Call Option has very high delta.
Now, what is Delta?
Basically, Delta is something that indicates that how much the option will move for a movement of $1 in the underlying asset. And, another definition states that what is the probability of the option to expire being in the money. It means high delta indicates high probability of the call option expiring in the money.
The above lines justifies that DITM Call Options do not have Time Premiums because they do not have time value or because it moves exactly with the stock. If the stock goes up $1, with high probability in place, the option also moves up similarly.
So, it is like purchasing the stock itself. so, it is better and make absolute sense to exercise the option because if there is dividend payment, exercising the option will fetch you dividends which wasn't possible had you decided not to exercise.
Also as per statement, if there is no upside potential in the stock, without premiums, exercising the option is the best decision.