ADF

Quiz #3

The following data is available regarding mispriced calls:

S0 = Rs. 100; rf =1.07; d=0.8; u=1.25; h = 0.556 share: 1 call (i.e. 556 share and 1000 call);
1. If call is overpriced:
C (theoretical value) = Rs. 14.02; C* (market price) =Rs. 15
Solution:
The call is overpriced, the call is to be sold (short) and H shares are to be bought:
V0 =556($100)-1,000($15) = $40,600.
At expiration, the call is properly priced, therefore, at Su call is priced 25 and at Sd call is priced at 0:
Vu =556($125)-1,000($25) = $44,500.
Vd =556($80)-1,000(0) = $44,800.
rhu = ($44,500/$40,600)-1=0.096 or 9.60%.
rhd = ($44,800/$40,600)-1=0.1034 or 10.34%.
It is treated as an investment.

2. If call is underpriced:
C (theoretical value) = Rs. 14.02; C* (market price) =Rs. 13
Solution:
The call is underpriced, the call is to be bought (Long) and H shares are to be sold:
V0 = -556($100) +1,000($13) = -$42,600.
At expiration, the call is properly priced, therefore, at Su call is priced 25 and at Sd call is priced at 0:
Vu = -556($125) +1,000($25) = -$44,500.
Vd = -556($80) +1,000(0) = -$44,800.
rhu = (-$44,500/-$42,600)-1=0.0446 or 4.46%.
rhd = (-$44,800/-$42,600)-1=0.0516 or 5.16%.
It is treated as borrowing.