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Portfolio management (3), q 23.3 in CMP

V

VSA_88

Active Member
Hi,
Can someone explain what I am missing here? Unfortunately I don't know how to attach any images. I am referring to question 23.3 in the CMP for Chapter 23.

Firstly, I drew my diagrams exactly the same except that my dot-dash line is my long put and the dashed is my short call. The answer has these the other way around.

Secondly, how do I find profits and losses of 300, -300 on the y-axis, respectively? Perhaps this has something to do with the intrinsic value point.
 
I believe you've spotted an error here in the course notes. I agree that the lines should be labelled as the other way round and it sounds like you have done in your answer.

In terms of the profits, on the y-axis, the value of the index here is 3600. The call option would not be exercised so we collect the 170 premium. The put option will be exercised and our profit would be payoff - premium ie (3900 - 3600) - 170 = 130. Combined together this is 300 profit.

At the other end of the graph the value of the index is 4400. The call option would be exercised and so we make a loss equal to 170 - (4400 - 4100) = -130. The put option will not be exercised and so we just lose our premium of 170. Combined together this is a loss of 300.

Because the net position at time 0 is 0 (because we pay 170 and receive 170) the profit in general is equal to the sum of the payoffs on the two options: max(3900 - index value, 0) - max(index value - 4100,0).

Joe
 
Hi Joe

Thanks for the help and the detailed response regarding the intrinsic values. It turns out that I am following that exactly as you have described except I did not use the values on x-axis as they were displayed in the answer (I was actually going all the way to an index value of 0!).

I greatly appreciate your help and thanks for responding very promptly.
 
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