Question #73 - Reading 31 Valuation of Contingent Claims

Reading: Reading 31 Valuation of Contingent Claims

PDF File: Reading 31 Valuation of Contingent Claims.pdf

Page: 34

Status: Unattempted

Correct Answer: A

Shared Context

- Susan discovers that the fair value for the $55 strike put is in fact $3.85. Which of the following is the most appropriate set of transactions to exploit the mispricing (ignore transaction costs)? A) Write a call option, buy a put option, buy one share, borrow the PV of strike. B) Buy a call option, write a put option, buy one share, borrow the PV of strike. C) Buy a call option, write a put option, sell short one share, put on deposit the PV of strike.

Question

Using information in Exhibit 2, which of the following statements about assumptions 1 and 2 is most accurate?

Answer Choices:

A. Both assumptions are correct

B. Only one of the two assumptions is correct

C. Both assumptions are incorrect

Explanation

The assumptions used by the basic BSM model include: The underlying asset price follows a geometric Brownian motion process. The continuously compounded return is normally distributed. Under this framework, change in asset price is continuous: there are no abrupt jumps. The (continuously compounded) risk-free rate is constant and known. Borrowing and lending are both at the risk-free rate. The volatility of the returns on the underlying asset is constant and known. Markets are "frictionless." There are no taxes, no transactions costs, and no restrictions on short sales or the use of short-sale proceeds. Continuous trading is possible, and there are no arbitrage opportunities in the marketplace. The (continuously compounded) yield on the underlying asset is constant. The options are European options (i.e., they can only be exercised at expiration). Assumption 1 is incorrect. Asset prices are lognormally distributed and asset returns are normally distributed. Assumption 2 is correct.

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