1) The call is an option on ABC Corp. with a $3 premium and a $55 exercise.
2) The put is an option on ABC Corp. with a $1 premium and a $45 exercise.
What is the value of the hedge with a 20% probability of ABC E(v) at $40, a 60% E(v) at $50 (current price), and a 20% E(v) at $60?
At
50, the value is: cost of the spread ($1 x 100 share
put) + ($3 x 100 share call). So 100 + 300 = $400
cost (or 400) of the spread.
1) The $50 per share level has no gain or loss with
a cost of 400, so at $50 per share the profit/loss
is $400.
2) At $60 per share, the put is worth zero since the price of the stock is more than the put's exercise price (45). The call is worth 6055 or $500 for 100 shares with a cost of 400, or a net of $100, so at $60 per share the profit/loss is $100.
3) At $40 per share, the call won't be exercised because the ABC stock price is under the exercise price of the call ($55). The put is worth 4540, or $500 with a cost of 400, so at $40 per share the profit/loss is $100.
Finally, sum the probabilities:
.6
* 400 = 240
.2 * 100 = 20
.2 * 100 = 20
The
value of the hedge turned out to be $200. What would
it be if there were a 40% chance of stability (no
gain or loss) and a 40% chance the put would be exercised
at an actual of 30? Knowing how these sensitivities
work, and the direction ups and downs take the end
result, is key to quick responses on many of the CFA
questions!
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