In 2007 April paper Q3 I don't understand why the the right hand side of the expiry graph (solid line of the ASET solution) should go below zero. If it goes below zero, that means there is an initial cost for setting up the portofolio. The inticial cost should be the net premium paid for construction the portoflio at the outset, which is also the net value of each option at time 0 and when the index price is 6000. This implies that the price for the two 5500 put - price for the 5000 put < 0 However, It goes on to say that to plot the dotted line (graph for now), when the index equals to 6000, the net profit at this point is zero. So that price for the two 5500 put - price for the 5000 put = 0 Isn't that contradictory? Am I miss understand the whole thing?
The flaw in your argument is that you have not included the value of the options in you statement: So that price for the two 5500 put - price for the 5000 put = 0 This should in fact be: (Cost of 2 5500 puts) - (Cost of 1 5000 put) - (Value of 2 5500 puts) + (Value of 1 5000 put) = 0 Which must be true. Hence the dotted line will be 0 at 6000.
I guess you had to guess the convexity (the amount of the non-linear response) of the put option to the strike prices I.e the fact that the 5500 put costs more that TWICE (I also missed this) the 5000 put.
