# similarities and the differences

Homework 4

Q1. Explain the similarities and the differences between ABS and ABS CDO.

Q2. Currently, the stock price is $40. A European call option with a strike price of $50 expiring in 2 years is trading at $20. And the put option with a strike price of $30 is trading at $15.

a. Suppose an investor buys 200 shares of stock, shorts 200 call options, and buys 200 put options. Construct a table showing the investor’s profits (not payoff) for a range of possible stock prices in 2 years. If you don’t know the difference between profit and payoff, review week 1 class. In addition, please remember that when the investor shorts an option, he receives (not pay) the option price upfront.

Here’s how to construct the Excel table: Create a column of stock prices in 2 years ranging from $1, $2, $3, … to $80. Then use the next 3 columns to calculate profits the stocks, calls, puts (one column for each position). Pay attention to whether it’s a long or a short position. Then add all the profits from these three positions (stock, call, put) to calculate the total profits in the next column. The final step is to graph these profits (y-axis) against the stock prices in the first column (x-axis). You can do this in Excel with Insert>Charts>Scatter. If you don’t know how, then type “scatter chart” in Excel help window and follow the instruction. Your profit for long put option should look similar to Figure 9.2 in page 213 and the profit for short call should look similar to Figure 9.3.

b. The strategy in part a is called “collar” strategy. Explain when an investor may want to use this strategy.

Q3: What are the differences between (a) (exchange-traded) call options and (b) warrants/employee stock options/convertibles?

Q4. The current price of a stock is $94, and a three-month European call option with a strike price of $95 currently sells for $4.70. An investor who feels that the price of the stock will increase is trying to decide between investing in 100 stocks and investing in 2,000 call options (20 contracts) for 3 months. Both strategies cost an initial investment of $9,400. How high does the stock price have to rise in 3 months for the option strategy to be more profitable than the stock strategy? In other words, at what stock price, will the 2 strategies result in the same profit?

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