Date: Monday, April 9, 2007
Case: Smith Barney, Harris Upham and Co., Inc. (UVA-F-0946)
Read: None
Network File: None
Class Objective:
Review arbitrage pricing and how it enforces pricing relationships among different financial assets, specifically among calls, puts, stocks and bonds
Assignment:
1. What is Put-Call parity? How does it depend on arbitrage in markets?
2. Using the following information, devise arbitrage strategies for trading. How would you go about instituting these trading rules for European options on non-dividend paying stocks? Can you make money?
a. Current XYZ stock price is $73
b. Current risk-free rate (continuous compounding) is 6%
c. Call option on XYZ with maturity of 6 months and an exercise price of $78 is trading for $ 6.30.
d. Put option on XYZ with maturity of 6 months and an exercise price of $78 is trading for $9.00.
e. What would be the case if the call price had been $6.94? What would you do it the stock price had been $73.25?
3. How would you go about instituting these trading rules for American options on non-dividend paying stocks?
4. What is the impact of dividends on Put-Call parity? How do you have to change the Put-Call parity formula to account for dividends? What alterations in your strategies would you have to make for European options on dividend paying stocks? What would be the concerns for American options on dividend paying stocks?
5. Smith Barney has a large inventory of stocks, which it holds in “street name”. These are stocks owned by customers but are held in Smith Barney’s name. Assuming that Smith Barney has an inventory of stocks on which puts and calls are traded, can Put-Call parity be used to lower Smith Barney’s cost of borrowing? If so, how?