You have been tasked with producing a report on the pricing of potential option investments being...

You have been tasked with producing a report on the pricing of potential option investments being considered by your investment fund employer. The asset underlying the options is a stock (RCOP) that has a current price of $35 and is expected to move up or down 25% during the upcoming year. The risk-free rate is 1.5% (APR with semi-annual compounding).

a) Your boss is enthusiastic about the put option and tells you that buying the proposed put option means the investment fund will not lose any money if RCOP falls below $30 over the next year. What would you say to your boss in response?

Expert Solution

I would say to my boss that there is an opportunity cost associated with investment in put option because there is loss of earning equal to the risk free rate and if he wants to invest into this put option that had just made probability of 25% of getting exercised which will have the benefit of lesser than the present value after taking the the probability factor into play

So, investment into put option is not advisable as there is an association of opportunity cost because if those capital would have been invested into risk free rate that would have a complete certainty of guaranteed return that would have yielded return equal to the risk free rate of 1.5% which have been compounded semi annually.

The return on put option is based on the probability and it is lower than the overall opportunity cost of risk free rate so I would advise my boss against investment into this put option.

jeff jeffy answered 2 years ago

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