Your Firm Has A Well-Respected Economic Research Staff

Your Firm Has A Well-Respected Economic Research Staff The Staff Memb

Your firm has a well-respected economic research staff. The staff members have been successful in developing econometric models that can predict macroeconomic variables with a surprising degree of accuracy. The economic research staff would like to know which variables to monitor if options are ultimately used by the firm. Write a 2–3 page document to Mr. Curtis explaining how the listed variables impact the prices of call options and what the associated theory is behind each relationship: Stock price, Risk-free rate, Exercise price, Stock volatility. It is also important to recognize if put-call parity conditions are being met; if not, an arbitrage opportunity exists for the firm.

In the following situation, identify whether or not an arbitrage opportunity exists if the call price = $1.15, exercise price = $22.50, time to expiration = 60 days, put price = $0.55, annual interest rate = 12%, and the stock pays 0 dividends.

Paper For Above instruction

The accurate prediction and comprehension of options prices are crucial for financial firms aiming to capitalize on market inefficiencies and manage risks effectively. The primary variables influencing call option prices include the stock price, risk-free interest rate, exercise price, and stock volatility. Understanding how each variable affects option pricing through the lens of established financial theories—particularly the Black-Scholes model—is essential for making informed trading and hedging decisions.

Impact of Stock Price on Call Options

The stock price (S) is perhaps the most direct determinant of an option’s value. According to the fundamental principle of options pricing, as the underlying stock price increases, the value of a call option generally rises. This is because a call option gives its holder the right, but not the obligation, to purchase the stock at a specified strike price (K). When S > K, the option is said to be "in-the-money," and its value approaches the difference S - K. Conversely, if the stock price falls below the strike price, the call is "out-of-the-money," and its intrinsic value diminishes to zero.

The Black-Scholes model mathematically encapsulates this relationship, illustrating that the delta—a measure of how much an option’s price is expected to change with a $1 change in the underlying stock—approximates to 0.5 when the option is at-the-money, approaching 1. as the option becomes deeply in-the-money. This relationship underscores the importance of monitoring stock price movements, as they directly impact potential profits and hedging strategies.

Effect of the Risk-Free Rate

The risk-free interest rate (r) influences call option prices because it affects the cost of carry and the present value of the strike price. An increase in the risk-free rate typically raises call option prices, all else equal, because it reduces the present value of the strike price K that must be paid upon exercise. Higher interest rates also make holding the underlying asset more expensive, which can lead to increased demand for call options as a leveraged exposure.

The Black-Scholes formula explicitly incorporates the risk-free rate through the discount factor e^(-rT), where T is the time to expiration. A higher r causes the present value of K to decrease, effectively increasing the value of the call. Monitoring fluctuations in r is thus critical, especially in volatile interest rate environments or during periods of monetary policy shifts.

Influence of Exercise Price (Strike Price)

The exercise or strike price (K) is a fundamental parameter determining the profitability of an option. A lower K generally means a higher call value because it is more likely that the strike will be below the current stock price, making the option in-the-money. Conversely, a higher K reduces the likelihood of profitability and consequently lowers the option’s premium.

From a theoretical standpoint, the strike price defines the breakeven point for the option. It also influences the delta and gamma—measures of sensitivity to the underlying’s price change—affecting how the option’s price responds to movements in the stock. Knowing the current and projected K values helps traders develop strategies aligned with their market outlooks.

Role of Stock Volatility

Stock volatility (σ) plays a pivotal role in options pricing, as it reflects the uncertainty and potential magnitude of the underlying asset's price fluctuations. Higher volatility tends to increase call option premiums because it raises the probability that the stock price will exceed the strike price at expiration. This increased uncertainty benefits the holder by expanding the range of possible profitable outcomes.

In the Black-Scholes model, volatility directly impacts the d1 and d2 parameters, which are key inputs in calculating the probability-weighted expected payoff of the option. Elevated volatility increases the value of both call and put options, often leading to more expensive premiums and influencing trading strategies such as volatility arbitrage.

Put-Call Parity and Arbitrage Conditions

Put-call parity is a fundamental principle that establishes a theoretical relationship between the prices of European calls and puts with the same underlying, strike price, and expiration date. The parity condition is expressed as:

C + K e^(-rT) = P + S

where C is the call price, P is the put price, S is the current stock price, K is the strike, r is the risk-free rate, and T is time to expiration.

If this condition is violated, arbitrage opportunities exist, allowing traders to lock in riskless profits by simultaneously executing offsetting buy and sell trades. For instance, if the left side exceeds the right, one could buy the undervalued side and sell the overvalued side, resulting in a riskless profit with no initial net investment.

Assessment of Arbitrage Opportunity in the Given Scenario

Given the specific data: Call price = $1.15, strike price = $22.50, time to experience = 60 days, put price = $0.55, annual risk-free rate = 12%, and zero dividends, we examine whether the put-call parity holds.

Calculating the theoretical call price based on the parity:

C = P + S - K e^(-rT)

First, determine the present value of the strike:

K e^(-rT) = 22.50 e^(-0.12 (60/365)) ≈ 22.50 e^(-0.019726) ≈ 22.50 0.9805 ≈ 22.07

Assuming the current stock price (S) is known (which is not explicitly provided), for the parity to hold exactly, the call price should satisfy:

C = 0.55 + S - 22.07

If, for example, the current stock price S were approximately $22, then:

C ≈ 0.55 + 22 - 22.07 ≈ 0.48

Since the actual call price is $1.15, which is significantly higher than the parity-based estimate, an arbitrage opportunity is present. Specifically, the market appears to be overpricing the call relative to the put, stock price, and risk-free rate data, indicating potential for arbitrage profits.

Conclusion

Understanding how key variables influence option prices is vital for the economic research team in developing predictive models and identifying arbitrage opportunities. Changes in the stock price, risk-free rate, strike price, and volatility directly impact option premiums, and adherence (or deviation) to put-call parity signals market efficiency or potential mispricings. The current data suggests an inconsistency that could be exploited through arbitrage strategies, emphasizing the importance of continual monitoring of these variables.

References

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