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 diagram shows that if the stock price is below $40 or above $80, the payoff is zero. If the stock price is between $40 and $80, the payoff is linearly increasing with the stock price. This suggests that we should buy a call option with a strike price of $80 (which will be exercised if the stock price is above $80) and buy a put option with a strike price of $40 (which will be exercised if the stock price is below $40). This will give us the desired payoff regardless of where the stock price ends up. Therefore, choice B is the correct answer.

Combining Options: Suppose You Are Creating a Portfolio That Consists