CHAPTER 3: PRINCIPLES OF OPTION PRICING MULTIPLE CHOICE TEST QUESTIONS 1. Consider a portfolio consisting of a long call wit an e!

ercise price of "# a s ort position in a non$ di%idend pa&ing stoc' at an initial price of S(# and t e p)rc ase of ris'less *onds wit a face %al)e of " and +at)ring w en t e call e!pires. , at s o)ld s)c a portfolio *e wort a. C . P / "01 . r1 $T *. C / S( c. P/ " d. P . S( / "01 . r1 $T e. none of t e a*o%e , at is t e lowest possi*le %al)e of a E)ropean p)ta. Ma!0(# " / S(1 *. "01 . r1 $T c. Ma!3(# S( / "01 . r1 $T4 d. Ma!3(# "01 . r1 $T / S(14 e. none of t e a*o%e 6not er e!pression for intrinsic %al)e is a. parit& *. parit& %al)e c. e!ercise %al)e d. all of t e a*o%e e. none of t e a*o%e On Marc 2# a Treas)r& *ill e!piring on 6pril 2( ad a *id disco)nt of 8.9(# and an as' disco)nt of 8.9:. , at is t e *est esti+ate of t e ris'$free rate as gi%en in t e te!ta. 8.9: ; *. 8.95 ; c. :.11 ; d. :.17 ; e. none of t e a*o%e S)ppose &o) )se p)t$call parit& to co+p)te a E)ropean call price fro+ t e E)ropean p)t price# t e stoc' price# and t e ris'$free rate. <o) find t e +ar'et price of t e call to *e less t an t e price gi%en *& p)t$ call parit&. Ignoring transaction costs# w at trades s o)ld &o) doa. *)& t e call and t e ris'$free *onds and sell t e p)t and t e stoc' *. *)& t e stoc' and t e ris'$free *onds and sell t e p)t and t e call c. *)& t e p)t and t e stoc' and sell t e ris'$free *onds and t e call d. *)& t e p)t and t e call and sell t e ris'$free *onds and t e stoc' e. none of t e a*o%e If t ere are no di%idends on a stoc'# w ic of t e following state+ents is correcta. 6n 6+erican call will sell for +ore t an a E)ropean call *. 6 E)ropean call will sell for +ore t an an 6+erican call c. 6n 6+erican call will *e i++ediatel& e!ercised d. 6n 6+erican call and an 6+erican p)t will sell for t e sa+e price e. none of t e a*o%e T e following =)otes were o*ser%ed for options on a gi%en stoc' on No%e+*er 1 of a gi%en &ear. T ese are 6+erican calls e!cept w ere indicated. Use t e infor+ation to answer =)estions > t ro)g 2(. ?t Edition@ C apter 5 1:2 Test Aan'

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Calls Stri'e 1(8 11( 118 No% 9.7( 7.7( 1.8( Dec 1( >.1( 5.?( Ean 11.8( 9.5( 8.5( No% 8.5( (.?( 2.9(

P)ts Dec 1.5( 2.8( 7.9( Ean 2.(( 5.9( 7.9(

T e stoc' price was 115.28. T e ris'$free rates were >.5( percent 0No%e+*er1# >.8( percent 0Dece+*er1 and >.:2 percent 0Ean)ar&1. T e ti+es to e!piration were (.(597 0No%e+*er1# (.1572 0Dece+*er1# and (.211 0Ean)ar&1. 6ss)+e no di%idends )nless indicated. >. , at is t e intrinsic %al)e of t e Dece+*er 118 p)ta. 1.>8 *. (.(( c. 5.?( d. 5.(( e. none of t e a*o%e , at is t e intrinsic %al)e of t e No%e+*er 1(8 p)ta. (.5( *. 9.28 c. 9.8( d. (.(( e. none of t e a*o%e , at is t e intrinsic %al)e of t e Ean)ar& 11( calla. (.(( *. 9.5( c. 5.>8 d. 8.(( e. none of t e a*o%e , at is t e intrinsic %al)e of t e No%e+*er 118 calla. 1.8( *. (.(( c. 2.9( d. 1.>8 e. none of t e a*o%e , at is t e ti+e %al)e of t e Dece+*er 1(8 p)ta. 1.5( *. 9.5( c. (.(( d. >.(( e. none of t e a*o%e

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, at is t e ti+e %al)e of t e No%e+*er 118 p)ta. 1.>8 *. 2.9( c. 1.1( d. (.(( t ? Edition@ C apter 5 1:5

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Test Aan'

e. 15.

none of t e a*o%e

, at is t e ti+e %al)e of t e No%e+*er 11( calla. (.(( *. 7.7( c. 1.18 d. 5.28 e. none of t e a*o%e , at is t e ti+e %al)e of t e Ean)ar& 118 calla. 8.5( *. (.(( c. 5.8( d. 1.>( e. none of t e a*o%e , at is t e E)ropean lower *o)nd of t e Dece+*er 1(8 calla. ?.9: *. (.(( c. 9.28 d. ?.2: e. none of t e a*o%e , at is t e E)ropean lower *o)nd of t e No%e+*er 118 calla. 1.77 *. (.(( c. 1.>8 d. 2.(: e. none of t e a*o%e Fro+ 6+erican p)t$call parit&# w at are t e +ini+)+ and +a!i+)+ %al)es t at t e s)+ of t e stoc' price and Dece+*er 11( p)t price can *ea. 1(1.91 and 1(2.9> *. 2.8( and 115.28 c. 11:.(59 and 11>.1( d. >.128 and 11( e. none of t e a*o%e T e +a!i+)+ difference *etween t e Ean)ar& 1(8 and 11( calls is w ic of t e followinga. 11.8( *. 7.?2 c. 8.(( d. 7.( e. none of t e a*o%e S)ppose &o) 'new t at t e Ean)ar& 118 options were correctl& priced *)t s)spected t at t e stoc' was +ispriced. Using p)t$call parit&# w at wo)ld &o) e!pect t e stoc' price to *e- For t is pro*le+# treat t e options as if t e& were E)ropean. a. 115.>5 *. 125.25 c. 121.25 d. 112.>> e. none of t e a*o%e

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18.

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19.

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2(. S)ppose t e stoc' is a*o)t to go e!$di%idend in one da&. T e di%idend will *e G7.((. , ic of t e ?t Edition@ C apter 5 Test Aan' 1:7
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following calls will &o) consider for e!ercisea. No%e+*er 118 *. No%e+*er 11( c. Dece+*er 118 d. all of t e a*o%e e. none of t e a*o%e 21. T e ti+e %al)e of an option is also referred to as t e a. s&nt etic %al)e *. stri'e %al)e c. spec)lati%e %al)e d. parit& %al)e e. none of t e a*o%e , ic of t e following is t e lowest possi*le %al)e of an 6+erican call on a stoc' wit no di%idendsa. Ma!0(# S( / "01 . r1 $T1 *. S( c. Ma!0(# S( / "1 d. Ma!0(# S( 01 . r1 $T / "1 e. none of t e a*o%e , ic of t e following is t e lowest possi*le %al)e of an 6+erican p)t on a stoc' wit no di%idendsa. "01 . r1 $T *. " c. Ma!0(# "01 . r1 $T / S(1 d. Ma!0(# " / S(1 e. none of t e a*o%e T e difference *etween a Treas)r& *illHs face %al)e and its price is called t e a. ti+e %al)e *. disco)nt c. co)pon rate d. *id e. none of t e a*o%e , ic of t e following state+ents a*o)t an 6+erican call is not tr)ea. Its ti+e %al)e decreases as e!piration approac es *. Its +a!i+)+ %al)e is t e stoc' price c. It can *e e!ercised prior to e!piration d. It pa&s di%idends e. none of t e a*o%e Ii%en a longer$li%ed 6+erican call and a s orter$li%ed 6+erican call wit t e sa+e ter+s# t e longer$ li%ed call +)st alwa&s *e wort a. at +ost t e %al)e of t e s orter$li%ed call *. at least as +)c as t e s orter$li%ed call c. e!actl& t e sa+e as t e s orter$li%ed call d. t e s orter$li%ed call disco)nted to t e lengt of t e longer$li%ed call e. none of t e a*o%e

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27.

28.

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, ic of t e following ine=)alities correctl& states t e relations ip *etween t e difference in t e prices of two E)ropean calls t at differ onl& *& e!ercise price a. 0"2 / "1101 . r1 $T J Ce0S(#T#"11 / Ce0S(#T#"21 *. 0"2 / "11 J Ce0S(#T#"21 / Ce0S(#T#"11 c. 0"2 / "1101 . r1 $T J Ce0S(#T#"11 . Ce0S(#T#"21 t ? Edition@ C apter 5 Test Aan' 1:8
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d. e. 29.

0"2 / "11 J Ce0S(#T#"11 / Ce0S(#T#"21 none of t e a*o%e

S)ppose t at &o) o*ser%e a E)ropean option on a c)rrenc& wit an e!c ange rate of S ( and a foreign ris'$ free rate of . , ic of t e following ine=)alities correctl& e!presses t e lower *o)nd of t e calla. Ce0S(#T#"1 J Ma!3(#S (01 . 1$T . "01 . r1 $T4 *. Ce0S(#T#"1 J Ma!3(#S ( $ "01 . 1$T4 c. Ce0S(#T#"1 J Ma!3(#S (01 . 1$T $ "4 d. Ce0S(#T#"1 J Ma!3(#S (01 . 1$T / "01 . r1 $T4 e. none of t e a*o%e 6 sit)ation in w ic earl& e!ercise of an 6+erican p)t can *e K)stified is a. *an'r)ptc& *. +erger c. if " e!ceeds S( *& greater t an an& transaction costs. d. *ot a and * e. *ot a and * and c T e effect of %olatilit& on a callLp)tMs price is a. decreased price d)e to decreased possi*le losses *. no+inal %olatilit& will not noticea*l& effect a callLp)tMs price c. increased price d)e to increased possi*le gains d. decreased price d)e to increased possi*le losses e. none of t e a*o%e

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Test Aan'

CHAPTER 3: PRINCIPLES OF OPTION PRICING TCUELF6LSE TEST QUESTIONS T T T T T T T T T T T T T T T T T T F F F F F F F F F F F F F F F F F F 1. 2. 5. 7. 8. :. >. 9. ?. 1(. 11. 12. 15. 17. 18. 1:. 1>. 19. 6n option can *e priced at less t an Nero *eca)se it can potentiall& generate a large profit for its owner. T e concept of t e intrinsic %al)e does not appl& to E)ropean calls prior to e!piration *eca)se t e& cannot *e e!ercised i++ediatel&. T e +a!i+)+ %al)e of a call is t e stoc' price. T e difference *etween an 6+erican callHs price and its intrinsic %al)e is called t e ti+e %al)e *eca)se t e call can *e e!ercised at an& ti+e. If one portfolio alwa&s pro%ides a ret)rn at least as ig as anot er portfolio# t en t at portfolio will a%e a price no less t an t at of t e ot er portfolio. P)t$call parit& is a relations ip t at can *e )sed to pro%ide t e price of *ot a E)ropean p)t and call si+)ltaneo)sl&. T e lower *o)nd of a E)ropean call on a non$di%idend pa&ing stoc' is lower t an t e intrinsic %al)e of an 6+erican call. 6n 6+erican call s o)ld *e e!ercised earl& w en t e stoc' price is e!tre+el& ig and is e!pected to fall. 6n 6+erican p)t +ig t *e e!ercised earl& e%en w en t ere are no di%idends on t e )nderl&ing stoc'. Holding e%er&t ing else constant# call options are +ore e!pensi%e in periods of ig interest rates. Holding e%er&t ing else constant# p)t options are +ore e!pensi%e in periods of ig interest rates. Hig %olatilit& is *ad for option olders *eca)se it increases t e pro*a*ilit& t at t e option will e!pire o)t$of$t e$+one&. T e lower *o)nd of a E)ropean p)t on a non$di%idend pa&ing stoc' is lower t an t e intrinsic %al)e of an 6+erican p)t. Holding e%er&t ing else constant# a longer$ter+ E)ropean p)t is alwa&s wort +ore t an a s orter$ter+ E)ropean p)t. T e lower t e e!ercise price# t e +ore %al)a*le t e call option. T e spread *etween t e prices of two E)ropean p)ts# ali'e in all respects e!cept e!ercise price# cannot e!ceed t e difference in t eir e!ercise prices. T e ti+e %al)e of a call is greatest w en t e stoc' price is %er& ig . E%en if t ere are no di%idends on t e stoc'# 6+erican p)t$call parit& will not *e t e sa+e as E)ropean p)t$call parit&. 1:> Test Aan'

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T T T T T T T T T T T

F F F F F F F F F F F

1?. 2(. 21. 22. 25. 27. 28. 2:. 2>. 29. 2?.

If an option portfolio generates a Nero cas flow at e!piration and a positi%e cas flow toda&# an ar*itrage opport)nit& is a%aila*le. 6n 6+erican call on a non$di%idend pa&ing stoc' will *e wort +ore t an a E)ropean call on t at sa+e stoc'. Transactions to e!ploit pricing errors in t e p)t$call parit& relations ip are called con%ersions and re%ersals. T e gain fro+ t e earl& e!ercise of an 6+erican p)t is "01 . r1 $T / S(. 6t e!piration t e call price +)st con%erge to t e stoc' price. 6 stoc' is e=)i%alent to a long call# s ort p)t and long ris'$free *ond. Selling s ort a ris'$free *ond is e=)i%alent to *orrowing. 6t e!piration# t e %al)e of a E)ropean call is ST / ". T e %al)e of a E)ropean call is ig er for lower stri'e prices. T e price of a call option is directl& related to interest rates. T e difference *etween two 6+erican p)t options wit different stri'e prices is less t an or e=)al to t e dollar difference *etween t e stri'e prices# t e ig er stri'e price +in)s t e lower stri'e price. T e p)t$call parit& r)le for 6+erican options is stated as e=)alities.

5(.

1(. 6 stoc' c)rrentl& trades at a price of G1((. T e stoc' price can go )p 1( percent or down 18 percent. T e ris'$ free rate is :.8 percent. 6. Use a one$period *ino+ial +odel to calc)late t e price of a call option wit an e!ercise price of G?(. A. S)ppose t e call price is c)rrentl& G1>.8(. S ow ow to e!ec)te an ar*itrage trans$ action t at will earn +ore t an t e ris'$free rate. Use 1(( call options. C. S)ppose t e call price is c)rrentl& G17. S ow ow to e!ec)te an ar*itrage transaction t at replicates a loan t at will earn less t an t e ris'$free rate. Use 1(( call options. 1(. C)rrent stoc' price# S O G1(( Up +o%e# ) O 1.1 Down +o%e# d O (.98 E!ercise price# " O G?( Cis'$free rate# r O :.8 percent 6. Stoc' prices one period fro+ now are

Call option %al)es at e!piration one period fro+ now are c. Ma!0(#llO $ ?(1 O G2( O

T e ris'$ne)tral pro*a*ilit& is ?t Edition@ C apter 5 1:9 Test Aan'

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T e call price toda& is

A. If t e c)rrent call price is G1>.8(# it is o%erpriced. T erefore# we s o)ld sell t e call and *)& t e )nderl&ing stoc'. T e edge ratio is

For e%er& option sold we s o)ld p)rc ase (.9 s ares of stoc'. If we sell 1(( calls we s o)ld *)& 9( s ares of stoc'. Sell 1(( calls at 1>.8( O 1#>8( A)& 9( s ares at 1(( O $9#((( Net cas flow O $:#28( 6t e!piration t e %al)e of t is co+*ination will *e 9(0981 $ 1((0(1 O G:#9(( if ST O 98 ,e in%ested G:#28( for a pa&off of G:#9((. T e rate of ret)rn is 0:#9((1:#28(1 $ 1 O (.(99. T is rate is ig er t an t e ris'$free rate of (.(:8. C. If t e c)rrent call price is G17# it is )nderpriced. T erefore# we s o)ld *)& t e call and sell t e )nderl&ing stoc'. T e edge ratio is

For e%er& option p)rc ased we s o)ld sell (.9 s ares of stoc'. If we *)& 1(( calls we s o)ld sell 9( s ares of stoc'. A)& 1(( calls at 17 O $ 1#7(( Sell 9( s ares at 1(( O 9#((( Net cas flow O :#:(( T )s# we generate G:#:(( )p front. C apter 7 Option Mar'ets and Contracts 287 6t e!piration t e %al)e of t is co+*ination will *e 1((02(1 $ 9(011(1 O $G:#9(( if ST O 11( 1((0(1 $ 9(0981 O $G:#9(( if ST O 98 ,e generated G:#:(( )p front and pa& *ac' G:#9((. T e rate of ret)rn is 0:#9((1:#:((1 $ 1 O (.(5(5. T is *orrowing rate is lower t an t e ris'$free rate of (.(:8. 12. Consider a two$period *ino+ial +odel in w ic a stoc' c)rrentl& trades at a price of G:8. T e stoc' price can go )p 2( percent or down 1> percent eac period. T e ris'$ free rate is 8 percent. 6. Calc)late t e price of a call option e!piring in two periods wit an e!ercise price of G:(. A. Aased on &o)r answer in P r 6# calc)late t e n)+*er of )nits of t e )nderl&ing at stoc' t at wo)ld *e needed at eac point in t e *ino+ial tree to constr)ct a ris'$ free edge. Use 1(#((( calls. C. Calc)late t e price of a call option e!piring in two periods wit an e!ercise price of G>(. D. Aased on &o)r answer in Pr C# calc)late t e n)+*er of )nits of t e )nderl&ing ?t Edition@ C apter 5 1:?

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Test Aan'

at stoc' t at wo)ld *e needed at eac point in t e *ino+ial tree to constr)ct a ris'$ free edge. Use 1(#((( calls. 12. C)rrent stoc' price# S O G:8 Up +o%e# ) O 1.2( Down +o%e# d O (.95 Cis'$free rate# r O 8 percent 6. E!ercise price# " O G:( Stoc' prices in t e *ino+ial tree one and two periods fro+ now are sH S) O:801.2(1 O G>9 O S$ O Sd :80(.951 O G85.?8 O s..O s)2 O :801.2(101.2(1 O G?5.:( SH$ S)d O :801.2(10(.951 O G:7.>7 O S$$ sd2O :80(.9510(.951 O G77.>9 O Call option %al)es at e!piration two periods fro+ now are

T e ris'$ne)tral pro*a*ilit& is 1.(8 $ (.95 $ (.8?7:# and 1 $ IT O (.7(87 O IT 1.2( $ (.95 Now find t e option prices at ti+e 1@ 28: C apter 7 Option Mar'ets and Contracts T e call price toda& is

A. T e edge ratios at eac point in t e *ino+ial tree are calc)lated as follows@ 6t t e c)rrent stoc' price of G:8#

T erefore# toda& at ti+e (# t e ris'$free edge wo)ld consist of a s ort position in 1(#((( calls and a long position in >#88? s ares of t e )nderl&ing stoc'. 6t a stoc' price of G>9#

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Test Aan'

Now t e ris'$free edge wo)ld consist of a s ort position in 1(#((( calls and a long position in 1(#((( s ares of t e )nderl&ing stoc'. 6t a stoc' price of G85.?8#

Now t e ris'$free edge wo)ld consist of a s ort position in 1(#((( calls and a long position in 2#5>8 s ares of t e )nderl&ing stoc'. C. E!ercise price# " O G>( Stoc' prices in t e *ino+ial tree one and two periods fro+ now are

S.. O s)2 O :801.2(101.2(1 O G?5.: S f $ O S)d O :801.2(10(.951 O G:7.>7 S $ $ O sd2 O :80(.9510(.951 O G77.>9 Call option %al)es at e!piration two periods fro+ now are

$$ $ >(1 O G( O Ma!0(#77.>9 c T e ris'$ne)tral pro*a*ilit& is $ (H95 O (.8?7:# and 1 $ r O (.7(87 O HIT 1.2( $ (.95 Now find t e option prices at ti+e 1@ 28> Sol)tions

T e call price toda& is

D. T e edge ratios at eac point in t e *ino+ial tree are calc)lated as follows. 6t t e c)rrent stoc' price of G:8#

T erefore# toda& at ti+e (# t e ris'$free edge wo)ld consist of a s ort position in 1(#((( calls and a long position in 8#888 s ares of t e )nderl&ing stoc'. 6t a stoc' price of G>9#

Now# t e ris'$free edge wo)ld consist of a s ort position in 1(#((( calls and a long position in 9#1>> s ares of t e )nderl&ing stoc'. ?t Edition@ C apter 5 1>1

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Test Aan'

6t a stoc' price of G85.?8# Pero s ares of t e )nderl&ing stoc' are needed for t e s ort position in calls.

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1>2

Test Aan'