You Are Convinced That the Next Three Months Are Going

question 121

Essay

You are convinced that the next three months are going to be boom or bust months for IBM.Foreseeing a major increase or decrease in the stock price,you set up a position in options where you buy July 120 calls at $8.75 and you buy July 120 puts at $8.25.IBM is currently selling for $119.
a. Draw the payoff diagram of cash flows on this position.
b. What are the break-even points on the upside and downside of this position?
c. Now assume that IBM has a variance of 0.08. Using the Black-Scholes model to value these two options, do you still think that you should take the above position? Why or why not? (Today is December 21, 2002; the options expire on July 18, 2003; the annualized riskless rate is 6%; ignore dividends.)
d. What is the implied variance in the July 120 call?

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Definitions:

Network Effects

The phenomenon whereby a product or service gains additional value as more people use it.

Economies of Scale

Cost advantages reaped by companies when production becomes efficient, as the average cost per unit of output decreases with increasing scale.

Monopolist

A sole provider of a particular good or service in a market, possessing the power to control prices and exclude competition.

Price Maker

A firm or entity that has significant control over the price of the goods or services it provides, due to lack of competition.