# Economics: I'm a so confused

Sigchi4life
Category:
Economics
Price: \$5 USD

Question description

Two different European GM call options are available in the market. Option A has an exercise price of \$95, trades at an implied annual volatility of 30% and costs \$3.7521 per call. Option B has a strike price of \$85, trades at an implied annual volatility of 20% and costs \$7.2748 per call. Both options are based on the same stock which is currently trading at \$90 and pays no dividends. The annual risk free rate is 5%. Both option prices are right in line with a Black-Scholes valuation.

a) You believe that all GM call option volatility is going to converge to 25% in the short term. Given this, set up a delta neutral strategy using these two options to take advantage of the convergence. Assume you want to trade 1,000 Option A calls.

b) Estimate the profit if the convergence happens immediately and the stock price stays at \$90.

c) What is the profit if the stock moves to \$89 or to \$91? How well is the hedge performing?

(Top Tutor) Daniel C.
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School: University of Virginia
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