63 Questions
A trading opportunity that offers a riskless profit is called a(n):
arbitrage.
The special contractual nature giving the owner the right to buy or sell an asset at a fixed price on or before a given date is the basis of:
an option.
In general, an option gives the holder the right to exercise at the ______ price through the ______ date.
strike; expiration.
Which of the following statements is true?
American options may be exercised anytime up to expiration. European options may be exercised only at expiration.
Which one of the following statements correctly describes your situation as the owner of an American call option?
You have the right to buy at a set price at any time up to and including the expiration date.
A call gives the owner the right:
but not the obligation to buy an asset at a given price.
Which of the following statements is true?
Call options are issued by investors and bought by investors.
You own a call option with time to expiration. The common stock is selling for $15 and your exercise price is $12, this option:
is in-the-money.
You can realize the same value as that derived from stock ownership if you:
sell a put and buy a call on a stock as well as invest at the risk-free rate of return.
The intrinsic value of a put is equal to the:
greater of the strike price minus the stock price or zero.
Which one of the following will cause the value of a call to decrease?
Lowering the risk level of the underlying security.
Pay-off diagrams for call options versus stock prices are called:
hockey stick diagrams.
The lowest value a call option can have is:
zero, because it is a limited liability instrument.
Which of the following is not true concerning call option writers?
The writer has the option to sell shares but not an obligation.
An in-the-money put option is one that:
has an exercise price greater than the underlying stock price.
An option that grants the right, but not the obligation, to sell shares of the underlying asset on a particular date at a specified price is called:
a European put.
Which one of the following provides the option of selling a stock anytime during the option period at a specified price even if the market price of the stock declines to zero?
American put
Which of the following statements is true?
Call options are in the money if the stock price is above the exercise price. Put options are in the money if the stock price is below the exercise price.
Jeff opted to exercise his August option on August 10 and received $2,500 in exchange for his shares. Jeff must have owned a (an):
American put.
A stock has both a call and a put option outstanding. The exercise price was set equal to the stock price. If the option were to expire now what would be the minimum value of the call and the put respectively?
0; 0.
A put gives the owner the right:
but not the obligation to sell an asset at a given price.
The payoff diagram for a put with the same exercise price and premium as the call on the same underlying asset with the same maturity is:
the mirror image of the call diagram around the exercise price.
When reading option price quotes from the Wall Street Journal or National Post, a price of "-" indicates that:
the option did not trade that day.
The put option allows:
the holder to sell shares if desired and requires the put seller to buy the shares at a fixed price.
Calls on the King Co. closed trading at 2 5/8. You bought 3 call contracts at the close. The cost of the 3 call options was:
$787.50 plus brokerage fees, etc.
What is the cost of five November 25 call option contracts on KNJ stock given the following price quotes? KNJ (KNJ) Underlying stock price: 30.86
$3,300
What is the intrinsic value of the August 25 call? KNJ (KNJ) Underlying stock price: 30.86
$5.86
Put-Call Parity can be used to show:
the precise relationship between put and call prices given equal exercise prices and equal expiration dates.
Suppose a stock can be purchased for $8.00, a put option on the stock can be purchased for $1.50, and a call option on the stock can be written (i.e., sold) for $1.00. If holding these positions in combination can guarantee a payoff of $10.00 at the end of the year, then what must be the risk-free rate if no arbitrage opportunities exist?
17.65%.
You own five put option contracts on XYZ stock with an exercise price of $25.00. What is the total intrinsic value of these contracts if XYZ stock is currently selling for $24.50 a share?
$250
A stock is selling for $31. There is a call option on the stock with an exercise price of $27. What is the approximate minimum value of the call option?
$4
You hold a put option on a stock with a strike price of $23. The stock is selling for $25. What is the approximate minimum value of the put option?
$23
The higher the exercise price:
the lower the call price.
Which of the following statements is true?
For both calls and puts an increase in the time to expiration will cause an increase in the option price.
If the volatility of the underlying asset decreases, then the:
value of both the put and call option will decrease.
If the time to expiration of the underlying stock decreases, then the:
value of both the put and call option will decrease.
Tele-Tech Com announces a major expansion into internet services. This announcement causes the price of Tele-Tech Com stock to increase but also causes an increase in price volatility of the stock. Which of the following correctly identifies the impact of these changes on the call option of TeleTech Com?
Both changes cause the price of the call option to increase.
Tele-Tech Com announces a major expansion into internet services. This announcement causes the price of Tele-Tech Com stock to increase but also causes an increase in price volatility of the stock. Which of the following correctly identifies the impact of these changes on the put option of TeleTech Com?
The greater uncertainty will cause the price of the put option to increase. The higher price of the stock will cause the price of the put option to decrease.
Tele-Tech Com has announced a large loss in their online services division causing the price of TeleTech Com stock to drop but the price volatility of the stock is not expected to drop. Which of the following correctly identifies the impact of these changes on the call option of TeleTech Com?
The volatility normally will have a positive effect on the price of the call option while the lower price of the stock will cause the price of the call option to decrease.
Tele-Tech Com has announced a large loss in their online services division causing the price of TeleTech Com stock to drop but the price volatility of the stock is not expected to drop. Which of the following correctly identifies the impact of these changes on the put option of TeleTech Com?
The volatility normally will have a positive effect on the price of the put option, but the lower price of the stock will cause the price of the put option to increase.
The Federal Reserve Board decreases open-market purchases, which results in a general increase in interest rates. As a result, the price of Specific Car stock drops. Which of the following correctly describes the impact of these changes on the price of the call option for Specific Car stock?
The higher interest rate will cause the price of the call option to increase. The lower price of the stock will cause the price of the call option to decrease.
The two-state OPM is so named because:
there are only two specific outcomes in the future period.
The Black-Scholes OPM is dependent on which five parameters?
Stock price, exercise price, risk free rate, variance and time to maturity.
You have entered into a call option contract for 1 period. The stock is selling for $28.00, you borrowed $12.00 at 8% and the delta is 0.6. What is the value of the call?
$4.80
To compute the value of a put using the Black-Scholes option pricing model, you:
first have to compute the value of the put as if it is a call.
In terms of relating options to the value of the firm, the equity of the firm can be viewed as:
a call option on the firm with the exercise price equal to the promised payments to the bondholders.
You own stock in a firm that has a pure discount loan due in six months. The loan has a face value of $50,000. The assets of the firm are currently worth $62,000. The stockholders in this firm own a _____ option on the assets of the firm with a strike price of _____
call; $50,000.
Verma Violin Manufacturing Corporation has issued debt with $10 million of principal due. In terms of viewing the equity of the firm as a call option, what happens to the equity of the firm if the cash flow of the firm is less than $10 million?
The option is out-of-the-money, the stockholders walk away, and the bondholders receive the entire cash flow.
Verma Violin Manufacturing Corporation has issued debt with $10 million of principal due. In terms of viewing the equity of the firm as a call option, what happens to the equity of the firm if the cash flow of the firm is greater than $10 million?
The option is in-the-money and the stockholders earn the difference between the cash flow and the bondholder's promised payment.
In terms of relating options to firm value, if the stockholders have a call option on the firm, what do the bondholders have?
In addition to owning the firm, they have written a call option against the firm whose exercise price equals the promised payment.
In relating stockholder value in terms of put options, the stockholders own the firm, they owe promised payments to the bondholders, and they have bought a put on the firm's assets with an exercise price equal to the promised payment to the bondholders. If the firm's cash flow is greater than these promised payments:
the put is out-of-the-money, is not exercised, and the stockholders retain ownership.
In relating stockholder value in terms of put options, the stockholders own the firm, they owe promised payments to the bondholders, and they have bought a put on the firm's assets with an exercise price equal to the promised payment to the bondholders. If the firm's cash flow is less than these promised payments:
the put is in-the-money, is exercised, and the stockholders walk away from their promise to the bondholders.
When a firm in financial distress accepts very risky projects, the stockholders benefit at the expense of the bondholders. In terms of option theory, the gain to the stockholders occurs because:
the stock is a call option on the firm's assets, and risky projects increase the volatility of those assets.
An insight gained by bringing the theory of options into standard capital budgeting analysis is:
projects, as call options, can be more valuable if the decision to start up the project is delayed until relevant information is released.
If a firm with risky debt outstanding pays a large cash distribution, the value of the bonds:
will decrease because the value of the put option will increase.
Suppose a situation exists where you can purchase a share of stock for $25, purchase a put option on the stock for $3, and write a call option against the stock for $4. Also, suppose that holding these three positions guarantees a payoff of $30 one year from today. If the risk-free rate is 20%, does put-call parity hold? If not, then what new price of the put option would allow put-call parity to hold?
Investment is $25 + $3 - $4 = $24. Guaranteed payoff = $30. Guaranteed return = ($24/$30) - 1 = 25% > 20%. P-C does not hold. The put price that would guarantee a return of 20% is $4.
Use the Black-Scholes model to determine the option price for the May 35 call for Nibblers as of April 18, 2015. The expiration date for this option is May 18, 2015. The annualized interest rate on a T-bill that matures that same day is 3.0%. Nibblers stock closed at 36. The historic variance for Nibblers is.25. Assume a 365 day year.
d1 = {ln(36/35) + [.03 + (.5)(.25)] * (30/365)}/((.25)(30/365)).5 =.2854 d2 =.2854 - ((.25)(30/365)).5 =.1421 N(d1 ) =.6124; N(d1 ) =.5565 C = (36 * .6124) - 35e-(.030)(.082192) *.5565 = $2.75
Use the Black-Scholes model to determine the option price for a call option which will expire in one year. The strike price is $17.50, the stock pays no dividends and has a current market price of $20.00. The volatility of the stock has resulted in an annualized standard deviation of 10%. The interest rate on a T-bill that matures in one year is 7%.
d1 = [ln(20/17.5) + 0.07 + (0.5*(0.1^2))1]/(SQRT((0.1^2)1)) = (0.133531 + 0.075)/0.1 = 2.08531 d2 = 2.08531 - 0.1 = 1.98531 N(d1) = 0.9814796 N(d2) = 0.9764452 e^(-0.071) = 0.932394 Call = (200.98148) - (17.50.9323940.97645) = 3.697 or $3.70
Explain how the value of a firm can be viewed as an option. How can the call and put views be resolved?
Call
- bondholders own firm
- bondholders sold call to stockholders
- stockholders exercise by paying debt amount Put
- bondholders are owed interest and principal
- bondholders sold put on the firm cash flow to stockholders
- stockholders exercise put when cash flows less than amount owed Can be resolved by Put-Call Parity. These are equivalent positions; as the value of call rises, put falls and vice-versa.
Options can be used to explain how the choice of a project can determine investor value. Options are also useful in evaluating alternatives open within a project choice, such as investing now or delaying. Give an example of how options can be used in investment timing.
- Every project can be viewed as an option--to invest or not to invest. If the NPV is positive, exercise the option to add value.
- Timing of an investment can be critical to value--time is a positive factor to option value.
- lengthening time to invest, delaying the choice until more information is revealed.
- a negative NPV alternative may be clearly avoided or an alternative course of action presented.
- Instructor should determine the reasonableness of an example.
Suppose your wealthy Aunt Minnie has asked you to manage her large stock portfolio. You would like to buy and/or sell options on many of the stocks she owns. Describe the types of options you would buy or sell, as well as your rationale, given the following circumstances: a. Aunt Minnie owns 10,000 shares of IBM common stock. You believe it is going to fall in price, but she won't let you sell it because her late husband told her never to let it go. How do you protect her from the impending price decline? b. Your analysis suggests that the common stock of Jet-Electro is poised to increase in value sharply over the next year. Aunt Minnie doesn't want to buy any of the stock but does want you to use options to profit if the price rises. What do you do? c. Although Aunt Minnie doesn't want you to sell any of the stocks she owns, she would like you to use options to generate a little extra income. How might you do this?
Looking at each option, we see: a. To profit from an expected price decline, you can offset your loss (assuming you don't wish to simply sell the stock) by either buying puts or selling (writing) covered calls on the stock. In this case, you would probably buy puts and sell them before expiration. b. In this case, the obvious solution is to buy calls and hope to sell them at a higher price later. You could also write puts, but Aunt Minnie would be forced to buy shares if you are wrong about the direction of the price change. c. You could sell puts as long as you are willing to buy the underlying security if the market moves against you. You do not want to sell covered calls if you are unwilling to sell your shares if the option is exercised. You do not want to sell naked calls as they have unlimited risk.
Explain the rationale behind the statement that equity is a call option on the firm's assets. When would a shareholder allow the call to expire?
The analogy only works for leveraged firms. At maturity of the firm's debt, the stockholders have the option to either pay the bondholders the par value of their debt or turn the firm's assets over to them. If the firm's assets are worth less than the par value of the debt, the stockholders will not exercise their call, that is, they will let the bondholders have the assets and the firm will be liquidated
What are the upper and lower bounds of an American call option? Explain what would happen in each case if the bound was violated.
The upper bound on a call is the stock price. If the call price exceeded the stock price, you would be paying more for the option to buy an asset than the asset itself costs. The lower bound: C ≥ 0 if S
- E < 0 and C ≥ (S - E) if (S - E) ≥ 0. In the first case, if the call exercise price exceeds the stock price, the call is out of the money and it will either be worthless or have a time premium. In the second case, if the call is in the money, the call must be worth at least the difference between the asset's value and the exercise price. If the call was worth less than this value, rational investors would purchase calls, immediately exercise them, and then sell the stock at the current market price, completing an arbitrage. If the stock price equals the exercise price, then the call is at the money and will have a value of zero or an amount equal to the time premium.
Test your knowledge about options trading with this quiz. Answer questions about trading opportunities, contractual rights, and option statements.
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