Question

10. Two months ago, firm X was responsible for a major environmental catastrophe. The stock price for X has fallen significantly since then. There is uncertainty about what the financial damage to the company will be in the future but there is a general expectation that they will pay a fine of $1 billion. You believe that this fine could be much higher but also a chance to be much lower. What derivative strategy should you pursue? What would the dollar profit be on that strategy if the ending stock price ends up being 140 at the expiration of the options and you invested $10,000 (ignoring transaction costs)? Exercise Prices X = 100 X = 105 Call Premium 14.23 11.98 Put Premium 9.35 11.86

Answer 1

Since the investor thinks that the fine could be much higher or much lower than the market is currently estimating. This means that the stock price can be much higher or lower than its current value. To make use of this opportunity, we can use the following strategy.

Buy a put at excercise price of 100

Buy a call at excercise price of 105  

Total cost of the strategy = 11.98 + 9.35 = 21.33$

The payoff graph for the startegy is as shown below:

Now, since we invested 10,000$, number of units of this strategy bought are = 10,000 / 21.33 = 469 units

When stock price is 140$ profit per unit is

Profit = Stock price - Excercise price of call - cost of strategy

= 140 - 105 -21.33

= 13.67 $

Thus profit per unit is 13.67 $

total profit = 13.67 * 469 = 6,411$