AcF 214 Tutorial Week 10

Question Explain under which conditions an increase in the dividend payment can be interpreted as a signal of (a) Good news; By increasing dividends managers signal that they believe that future earnings will be high enough to maintain the new dividend payment. (b) Bad news; Raising dividends signals that the firm does not have any positive NPV investment opportunities, which is bad news.

Question 20.4 Difference between long position in a put & short position in a call?  When a party has a long position in a put it has the right to sell the underlying asset at the strike price.  Payoff long-put = max(K-S T, 0)  Profit long-put = max(K-S T, 0) – p 0  When it has a short position in a call, it has the obligation to sell the underlying asset at the strike price if exercised.  Payoff short-call = - max(0, S T -K)  Profit short-call = c 0 - max(0, S T -K)  These are clearly different positions!

Question 20.6 Call option, K=$40, 3 months to expire (a) S=$55 - Payoff? C=max(55-40, 0)=$15 (b) S=$35 - Payoff? C=max(35-40, 0)=$0 (c) Payoff diagram

Question 20.7 Assume that you have shorted the call option in 20.7 (a) S=$55 – What will you owe? You owe $15 (-max(55-40, 0)=-$15) (b) S=$35 – What will you owe? You owe nothing (-max(35-40, 0)=$0) (c) Payoff diagram

Question Long in call & put option (same stock & exercise date); K(call)=$40, K(put)=$45; Plot P+C as a function of S T. S T ≤ 4040< S T ≤ 45S T ≥ 45 Call (K=40)0S T - 40 Put (K=45)45 - S T 0 Call+Put45 - S T 5S T - 40