Answer to Question #285319 in Financial Math for Red

Question

found two call options A and B, both options sell in the market for $4, for an underlying stock which currently sells at $15. Both options mature in one year, and the risk free rate is 6% and a variance of 4%. Upon maturity, you can exercise option A for $10, and option B for $20.

Which option you choose to buy? Explain your answer.

Answer 1

Solution:

Call option will be profitable if underlying stock price on expiry is more than exercise price.

Profit for Long Call = max of (Price on expiry - Exercise Price, 0) - Premium

In this case we have two call options A & B with same price, same underlying stock and same expiry but different exercise prices.

Exercise price for call option A is $ 10 and for call option B is $ 20. Here buying call option A is more profitable than call option B, because call option A exercise price is less than call option B.