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Compound options are usually cheaper than vanilla options and we know that there are four main types of compound options: a call on a call; a put on a call; a call on a put; a put on a put.
a) Explain the difference of these compound options.
b) Consider a put on call option that gives the option holder the right to sell a call option for 34, three months from today. The strike on the underlying call option is 530, the time to maturity on the call is six months from today, the price on the underlying stock index 500, the risk free interest rate is 7%, and the stock index pays dividend at a rate of 2.48% annually and has a volatility of 25%. Write the formula you would use to value this compound option.
c) Explain the meaning of the different variables.
d) Calculate the cumulative probability of the standardized bivariate normal distribution using the Drezner approximation and compare your results with the values obtained in excel using the function BiNorm(a,b,ρ).
e) Calculate the value of the critical value I needed to price this put on the call.
f) Calculate the value of this compound option.
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