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Q27I

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Essentials Of Investments
Found in: Page 516
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

You write a call option with X = $50 and buy a call with X = $60. The options are on the same stock and have the same expiration date. One of the calls sells for $3; the other sells for $9.

a. Draw the payoff graph for this strategy at the option expiration date.

b. Draw the profit graph for this strategy.

c. What is the break-even point for this strategy? Is the investor bullish or bearish on the stock?

Answer

a & b. As below

c. $56; bearish.

See the step by step solution

Step by Step Solution

Step 1: Drawing a payoff graph with given information “a, b”

Position

ST < 50

50 < ST < 60

ST > 60

Long call (X=60)

0

0

ST - 60

Short call (X=50)

0

-(ST – 50)

-(ST – 50)

Total

0

-(ST – 50)

-10

From the above, it’s clear that the payoff is either zero or negative.

Step 2: Explanation on “break even” and investor’s bullish/bearish ‘c’

The proceeds = $9 - $3 = $6

Breakeven would happen when the payoff even out the proceeds of $6.

This happens at stock price of ST = $56.

The investor is bearish as he entered into bear spread.

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