Chapter 15, Problem 6PS

Summary Introduction

Call option:

it is an agreement where the buyer is entitled to buy a stock at a pre-specified price (known as exercise price or strike price) within a pre-specified period. The stock on which the call option is provided is called the underlying asset.

Pay off from a call option:

The payoff from a call contract for its holder is the current price of the underlying asset less the strike price. So, lower the strike price compared to the current price of the underlying asset, higher is the value of the call option. In other words, the worth of call options increases with the difference between the price of underlying asset and the strike price where the stock price of underlying asset is more than the strike price. And the worth of a call option dictates the purchase price of a call option. More worthy the call option, higher will be its purchase price.

When the strike price is more than the stock price, the exercise of call option will cause negative cash flow. So, in that case, call option is not exercised and causes zero payoff.

Profit from a call option:

The profit from a call contract for its holder is the payoff from a call option less its purchase price, paid earlier.

To compute:

The stock price at which the investor will break even on the purchase of the call