Question

Xylem’s stock is currently selling at $200 per share. A one-year American call option with strike price $50 trading on the Acme options exchange sells for $75.

(1) (2 pts.) How would you take this opportunity to make a profit?

(2) (2 pts.) Suppose the option is a European call option instead, what is your strategy to make a profit?

Answer 1

(1)

If it is an american option:

Buy option for $75

Exercise option and buy stock for $50.

Then stock for $200 immediately.

Profit = $200 - $75 - $50 = $75.

(2)

In case of european option:

Short sell the stock for $200.

Purchase call option at $75 and wait until expiration.

If stock price on expiration is above $50 then exercise option , buy stock for $50 and return the stock to broker.

Net profit is same at $75.

If stock price on expiration is below $50 then let option expire, buy stock in market at spot price on expiration, return the stock to broker.

Profit is $75 plus stock price on expiration less $50.

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