LM 9: Option Replication Using Put-Call Parity

Question 1

What is fiduciary call composed of?

Answer 1

long risk free asset (zero coupon bond)

long call option on asset

Question 2

What is a protective put composed of?

Answer 2

long an asset

long put option on asset

Question 3

What is the put- call parity relationship formula?

Answer 3

S0 + P0 = (x / (1 + r) ^T) + C0

S0 = initial price of underlying
P0 = put premium
C0= call premium
r = annual interest rate
x = strike price of call
(x/(1+r)^T) = risk free bond

Question 4

What is the put- call forward parity relationship formula?

Answer 4

(F0 (T)/ (1+r)^T) + p0 = c0 + (x/ (1+r) ^T)

F0 (T) = forward price
(X/ (1+r) ^t) = risk free bond

Question 5

What is the firm value equation?

Answer 5

V0 = E0 + PV (D)

V0 = firm total market value at time 0
E0 = value of firm equity
D = PV of debt

Question 6

What is the payoff profit for capital providers formula and use?

Answer 6

determine how much goes to debt and equity holders

V0 + P0 = C0 + PV (D)

V0 = firm total market value at time 0 (price of underlying or owning the underlying)
P0 = put premium
C0= call premium
PV (D) = present value of debt (aka risk free bond)

Question 7

What is solvency and the formula for solvency and what is the formula that debt holders vs equity owners receive if firm is solvent?

Answer 7

solvency: firm is worth more than value of debt (VT>D)

debt holders: received D
equity owners: receive VT-D

Question 8

What is insolvency and the formula for insolvency and what is the formula that debt holders vs equity owners receive if firm is insolvent?

Answer 8

Insolvency: firm is worth less than the value of debt (VT<D)

Debt holders: receive value of firms assets (VT<D)
Equity owners: receive nothing

Question 9

What is the payoffs formula for debt holders vs equity owners?

Answer 9

Debt holders: min (D, VT)
Equity owners: max (0, VT-D)

VT = value of firm
D = value of debt