Combining options: Suppose you are creating a portfolio that consists of zero-interest bonds, stock from a single company, and call and put options on the stock. Holding which of the following combination of securities will give the payoff shown in the following diagram?

Question

Quizplus · Accepted Answer

The payoff diagram shows a flat line at $20 for all stock prices below $60, and a diagonal line with a slope of -1 for all stock prices above $60. This means that the investor wants to earn a steady $20 return (which can be achieved by buying risk-free bonds), and participate in the upside potential of the stock up to the strike price of $60 (which can be achieved by selling a call option with a strike price of $60). This is exactly what choice A offers: buying $20 in risk-free bonds and selling short one call option with a strike price of $60. Therefore, choice A is the best choice.

Combining Options: Suppose You Are Creating a Portfolio That Consists