Question

Consider three calls on the same stock (that pays no dividends)  that differ only in their strike prices. The strike prices are K1=35<K2=40<K3=45 (K1 is the smallest and K3 the largest). Now define w=(K3-K2)/(K3-K1) and consider the portfolio of w long positions in the K1 strike , (1-w) positions in the K3 strike, and one short position in the K2 strike.

Does this portfolio look like anything you might know?

Can you rank wC(K1)+(1-w)C(K3) and C(K2)? You are informed that the market prices of these calls are as follows:

C(K1)=5.50, C(K2)=3.85 and C(K3)=1.50

Are these correctly priced in the market relative to each other?

Is there anything for you to do?

Answer 1