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Chapter 15 Practice Question 15.1

Discussion in 'CM2' started by George Philip, Feb 5, 2022.

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  1. George Philip

    George Philip Active Member

    A building society issues a one-year bond that entitles the holder to the return on a weighted-average share index (ABC500) up to a maximum level of 30% growth over the year. The bond has a guaranteed minimum level of return so that investors will receive at least x% of their initial investment back. Investors cannot redeem their bonds prior to the end of the year.

    (i) Explain how the building society can use a combination of call and put options to prevent
    making a loss on these bonds.

    The question asks us to find the right combination of call and put options to prevent making a loss.
    The solution asks us to draw a graph of the payoff of the bond and compare with the graphs of each short and long position of calls and put options.

    Is there a process to follow in connecting the graphs to achieve the correct combination or are the graphs drawn simply to give us more clarity of the question?
     
    George Philip, Feb 5, 2022
    #1
  2. Steve Hales

    Steve Hales ActEd Tutor Staff Member

    If you can find the correct combination without drawing the graph then that's fine. However, the graph will probably make things a lot easier. Once the graph is drawn you then need to replicate it using the payoffs from European call and puts options, ie shapes like _/ and \_ respectively.
    Every time you see a bend or discontinuity in your graph it indicates that you'll need another derivative to start paying out at that location.
     
    Steve Hales, Feb 7, 2022
    #2

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