Consider a 6-month bull call spread on MDLZ with strikes of $35 and $50. MDLZ sp
ID: 2793444 • Letter: C
Question
Consider a 6-month bull call spread on MDLZ with strikes of $35 and $50. MDLZ spot price is $43 and its volatility is 20%. The risk-free rate is 4% per annum continuously compounded. We assume that MDLZ is not expected to pay any dividend. (a) Use a 6-step binomial tree to price the spread (note: up and dowr movements need to match the volatility. Show all the tree parameters). (4 marks) (b) What are the break-even point(s), the maximum profit and maximum loss for this strategy? (3 marks) (c) Without using the binomial tree, what is the premium of the bear put spread with the same strike prices? Explain (Clue: you can use put call parity to explain). (3 marks) 125 wordsExplanation / Answer
Soln : Bull call spread strategy is to buy call option at certain strike price and same no. of option to be sold with higher strike price but of same maturity.
Using binomial tree model here, calculate u, upward price and d = downward price
u = esd*(t/n)^0.5 = 1.06, d = 0.94, Probability , p for price up = (ert/n - d)/(u-d) = 52% and 1-p = 48%
We are considering the european option here
At t=6 the values at 7 nodes will be 60.8, 54.17, 48.26, 43, 38.3, 34.13, 30.41
At node 1 the value = 60.8 , hence net gain = 0
At node 2, value = 54.17, So again the net gain = 0
At node 3, Value = 48.26, net gain = 48.26-35 = 13.26, at node 4 net gain = 43-35 = $8
at node 5, net gain = 38.3 - 35 = $3.3, on nides 6 & 7 it will be 0
On solving with probability and time value of money, we get the value of this bull call spread as $5.18
(b) Max. Gain from this spread = Spread among the 2 strike prices - premium paid for the spread = 50-35-5.18 = $9.82
Max. loss from the bull call spread = Net premium paid = $5.18
Breakeven point = Strike price of long call + premium paid = 35 +5.18 = $ 40.18
c) Bear put strategy is applied when the price is expected to fall and buys a put option along with writing a put option with lower strike price and same maturity
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