Chapter 21 - Option Valuation

Chapter 21
Option Valuation
Multiple Choice Questions
1. Before expiration, the time value of an in the money call option is always
A. equal to zero.
B. positive.
C. negative.
D. equal to the stock price minus the exercise price.
E. none of the above.
The difference between the actual option price and the intrinsic value is called the time value
of the option.

Difficulty: Easy

2. Before expiration, the time value of an in the money put option is always
A. equal to zero.
B. negative.
C. positive.
D. equal to the stock price minus the exercise price.
E. none of the above.
The difference between the actual option price and the intrinsic value is called the time value
of the option.

Difficulty: Easy

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3. Before expiration, the time value of an at the money call option is always
A. positive.
B. equal to zero.
C. negative.
D. equal to the stock price minus the exercise price.
E. none of the above.
The difference between the actual option price and the intrinsic value is called the time value
of the option.

Difficulty: Easy

4. Before expiration, the time value of an at the money put option is always
A. equal to zero.
B. equal to the stock price minus the exercise price.
C. negative.
D. positive.
E. none of the above.
The difference between the actual option price and the intrinsic value is called the time value
of the option.

Difficulty: Easy

5. At expiration, the time value of an in the money call option is always

A. equal to zero.
B. positive.
C. negative.
D. equal to the stock price minus the exercise price.
E. none of the above.
The difference between the actual option price and the intrinsic value is called the time value
of the option.

Difficulty: Easy

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6. At expiration, the time value of an in the money put option is always

A. equal to zero.
B. negative.
C. positive.
D. equal to the stock price minus the exercise price.
E. none of the above.
The difference between the actual option price and the intrinsic value is called the time value
of the option.

Difficulty: Easy

7. At expiration, the time value of an at the money call option is always

A. positive.
B. equal to zero.
C. negative.
D. equal to the stock price minus the exercise price.
E. none of the above.
The difference between the actual option price and the intrinsic value is called the time value
of the option.

Difficulty: Easy

8. At expiration, the time value of an at the money put option is always

A. equal to zero.
B. equal to the stock price minus the exercise price.
C. negative.
D. positive.
E. none of the above.
The difference between the actual option price and the intrinsic value is called the time value
of the option.

Difficulty: Easy

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9. A call option has an intrinsic value of zero if the option is

A. at the money.
B. out of the money.
C. in the money.
D. A and C.
E. A and B.
Intrinsic value can never be negative; thus it is set equal to zero for out of the money and at
the money options.

Difficulty: Easy

10. A put option has an intrinsic value of zero if the option is

A. at the money.
B. out of the money.
C. in the money.
D. A and C.
E. A and B.
Intrinsic value can never be negative; thus it is set equal to zero for out of the money and at
the money options.

Difficulty: Easy

11. Prior to expiration

A. the intrinsic value of a call option is greater than its actual value.
B. the intrinsic value of a call option is always positive.
C. the actual value of call option is greater than the intrinsic value.
D. the intrinsic value of a call option is always greater than its time value.
E. none of the above.
Prior to expiration, any option will be selling for a positive price, thus the actual value is
greater than the intrinsic value.

Difficulty: Moderate

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12. Prior to expiration

A. the intrinsic value of a put option is greater than its actual value.
B. the intrinsic value of a put option is always positive.
C. the actual value of put option is greater than the intrinsic value.
D. the intrinsic value of a put option is always greater than its time value.
E. none of the above.
Prior to expiration, any option will be selling for a positive price, thus the actual value is
greater than the intrinsic value.

Difficulty: Moderate

13. If the stock price increases, the price of a put option on that stock __________ and that of
a call option __________.
A. decreases, increases
B. decreases, decreases
C. increases, decreases
D. increases, increases
E. does not change, does not change
As stock prices increases, call options become more valuable (the owner can buy the stock at
a bargain price). As stock prices increase, put options become less valuable (the owner can
sell the stock at a price less than market price).

Difficulty: Moderate

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14. If the stock price decreases, the price of a put option on that stock __________ and that of
a call option __________.
A. decreases, increases
B. decreases, decreases
C. increases, decreases
D. increases, increases
E. does not change, does not change
As stock prices decreases, call options become less valuable (the owner can buy the stock at a
bargain price). As stock prices decreases, put options become more valuable (the owner can
sell the stock at a price less than market price).

Difficulty: Moderate

15. Other things equal, the price of a stock call option is positively correlated with the
following factors except
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. none of the above.
The exercise price is negatively correlated with the call option price.

Difficulty: Moderate

16. Other things equal, the price of a stock call option is positively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. A, B, and C.
The exercise price is negatively correlated with the call option price.

Difficulty: Moderate

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17. Other things equal, the price of a stock call option is negatively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. A, B, and C.
The exercise price is negatively correlated with the call option price.

Difficulty: Moderate

18. Other things equal, the price of a stock put option is positively correlated with the
following factors except
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. none of the above.
The exercise price is negatively correlated with the stock price.

Difficulty: Moderate

19. Other things equal, the price of a stock put option is positively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. B, C, and D.
The exercise price is negatively correlated with the stock price.

Difficulty: Moderate

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20. Other things equal, the price of a stock put option is negatively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. B, C, and D.
The exercise price is negatively correlated with the stock price.

Difficulty: Moderate

21. The price of a stock put option is __________ correlated with the stock price and
__________ correlated with the striking price.
A. positively, positively
B. negatively, positively
C. negatively, negatively
D. positively, negatively
E. not, not
The lower the stock price, the more valuable the call option. The higher the striking price, the
more valuable the put option.

Difficulty: Moderate

22. The price of a stock call option is __________ correlated with the stock price and
__________ correlated with the striking price.
A. positively, positively
B. negatively, positively
C. negatively, negatively
D. positively, negatively
E. not, not
The lower the stock price, the more valuable the call option. The higher the striking price, the
more valuable the put option.

Difficulty: Moderate

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23. All the inputs in the Black-Scholes Option Pricing Model are directly observable except
A. the price of the underlying security.
B. the risk free rate of interest.
C. the time to expiration.
D. the variance of returns of the underlying asset return.
E. none of the above.
The variance of the returns of the underlying asset is not directly observable, but must be
estimated from historical data, from scenario analysis, or from the prices of other options.

Difficulty: Moderate

24. Which of the inputs in the Black-Scholes Option Pricing Model are directly observable
A. the price of the underlying security.
B. the risk free rate of interest.
C. the time to expiration.
D. the variance of returns of the underlying asset return.
E. A, B, and C.
The variance of the returns of the underlying asset is not directly observable, but must be
estimated from historical data, from scenario analysis, or from the prices of other options.

Difficulty: Moderate

25. Delta is defined as

A. the change in the value of an option for a dollar change in the price of the underlying asset.
B. the change in the value of the underlying asset for a dollar change in the call price.
C. the percentage change in the value of an option for a one percent change in the value of the
underlying asset.
D. the change in the volatility of the underlying stock price.
E. none of the above.
An option's hedge ratio (delta) is the change in the price of an option for $1 increase in the
stock price.

Difficulty: Moderate

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26. A hedge ratio of 0.70 implies that a hedged portfolio should consist of
A. long 0.70 calls for each short stock.
B. short 0.70 calls for each long stock.
C. long 0.70 shares for each short call.
D. long 0.70 shares for each long call.
E. none of the above.
The hedge ratio is the slope of the option value as a function of the stock value. A slope of
0.70 means that as the stock increases in value by $1, the option increases by approximately
$0.70. Thus, for every call written, 0.70 shares of stock would be needed to hedge the
investor's portfolio.

Difficulty: Moderate

27. A hedge ratio of 0.85 implies that a hedged portfolio should consist of
A. long 0.85 calls for each short stock.
B. short 0.85 calls for each long stock.
C. long 0.85 shares for each short call.
D. long 0.85 shares for each long call.
E. none of the above.
The hedge ratio is the slope of the option value as a function of the stock value. A slope of
0.85 means that as the stock increases in value by $1, the option increases by approximately
$0.85. Thus, for every call written, 0.85 shares of stock would be needed to hedge the
investor's portfolio.

Difficulty: Moderate

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28. A hedge ratio for a call option is ________ and a hedge ratio for a put option is ______.
A. negative, positive
B. negative, negative
C. positive, negative
D. positive, positive
E. zero, zero
Call option hedge ratios must be positive and less than 1.0, and put option ratios must be
negative, with a smaller absolute value than 1.0.

Difficulty: Moderate

29. A hedge ratio for a call is always

A. equal to one.
B. greater than one.
C. between zero and one
D. between minus one and zero.
E. of no restricted value
Call option hedge ratios must be positive and less than 1.0, and put option ratios must be
negative, with a smaller absolute value than 1.0.

Difficulty: Moderate

30. A hedge ratio for a put is always

A. equal to one.
B. greater than one.
C. between zero and one
D. between minus one and zero.
E. of no restricted value
Call option hedge ratios must be positive and less than 1.0, and put option ratios must be
negative, with a smaller absolute value than 1.0.

Difficulty: Moderate

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31. The dollar change in the value of a stock call option is always
A. lower than the dollar change in the value of the stock.
B. higher than the dollar change in the value of the stock.
C. negatively correlated with the change in the value of the stock.
D. B and C.
E. A and C.
The slope of the call option valuation function is less than one.

Difficulty: Moderate

32. The percentage change in the stock call option price divided by the percentage change in
the stock price is called
A. the elasticity of the option.
B. the delta of the option.
C. the theta of the option.
D. the gamma of the option.
E. none of the above.
Option price elasticity measures the percent change in the option price as a function of the
percent change in the stock price.

Difficulty: Moderate

33. The elasticity of an option is

A. the volatility level for the stock that the option price implies.
B. the continued updating of the hedge ratio as time passes.
C. the percentage change in the stock call option price divided by the percentage change in
the stock price.
D. the sensitivity of the delta to the stock price.
E. A and C.
Option price elasticity measures the percent change in the option price as a function of the
percent change in the stock price.

Difficulty: Moderate

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34. The elasticity of a stock call option is always

A. greater than one.
B. smaller than one.
C. negative.
D. infinite.
E. none of the above.
Option prices are much more volatile than stock prices, as option premiums are much lower
than stock prices.

Difficulty: Moderate

35. The elasticity of a stock put option is always

A. positive.
B. smaller than one.
C. negative
D. infinite
E. none of the above.
As put options become more valuable as stock prices decline, the elasticity of a put option
must be negative.

Difficulty: Moderate

36. The gamma of an option is

A. the volatility level for the stock that the option price implies.
B. the continued updating of the hedge ratio as time passes.
C. the percentage change in the stock call option price divided by the percentage change in the
stock price.
D. the sensitivity of the delta to the stock price.
E. A and C.
The gamma of an option is the sensitivity of the delta to the stock price.

Difficulty: Moderate

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37. Delta neutral

A. is the volatility level for the stock that the option price implies.
B. is the continued updating of the hedge ratio as time passes.
C. is the percentage change in the stock call option price divided by the percentage change in
the stock price.
D. means the portfolio has no tendency to change value as the underlying portfolio value
changes.
E. A and C.
Delta neutral means the portfolio has no tendency to change value as the underlying portfolio
value changes.

Difficulty: Moderate

38. Dynamic hedging is

A. the volatility level for the stock that the option price implies.
B. the continued updating of the hedge ratio as time passes.
C. the percentage change in the stock call option price divided by the percentage change in the
stock price.
D. the sensitivity of the delta to the stock price.
E. A and C.
Dynamic hedging is the continued updating of the hedge ratio as time passes.

Difficulty: Moderate

39. Volatility risk is

A. the volatility level for the stock that the option price implies.
B. the risk incurred from unpredictable changes in volatility.
C. the percentage change in the stock call option price divided by the percentage change in the
stock price.
D. the sensitivity of the delta to the stock price.
E. A and C.
Volatility risk is the risk incurred from unpredictable changes in volatility.

Difficulty: Moderate

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40. Portfolio A consists of 150 shares of stock and 300 calls on that stock. Portfolio B consists
of 575 shares of stock. The call delta is 0.7. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B
B. Portfolio A
C. The two portfolios have the same exposure
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
300 calls (0.7) = 210 shares + 150 shares = 360 shares; 575 shares = 575 shares.

Difficulty: Difficult

41. Portfolio A consists of 500 shares of stock and 500 calls on that stock. Portfolio B consists
of 800 shares of stock. The call delta is 0.6. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B
B. Portfolio A
C. The two portfolios have the same exposure
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
500 calls (0.6) = 300 shares + 500 shares = 800 shares; 800 shares = 800 shares.

Difficulty: Difficult

42. Portfolio A consists of 400 shares of stock and 400 calls on that stock. Portfolio B consists
of 500 shares of stock. The call delta is 0.5. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B
B. Portfolio A
C. The two portfolios have the same exposure
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
400 calls (0.5) = 200 shares + 400 shares = 600 shares; 500 shares = 500 shares.

Difficulty: Difficult

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43. Portfolio A consists of 600 shares of stock and 300 calls on that stock. Portfolio B consists
of 685 shares of stock. The call delta is 0.3. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B
B. Portfolio A
C. The two portfolios have the same exposure
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
300 calls (0.3) = 90 shares + 600 shares = 690 shares; 685 shares = 685 shares.

Difficulty: Difficult

44. A portfolio consists of 100 shares of stock and 1500 calls on that stock. If the hedge ratio
for the call is 0.7, what would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. +$700
B. +$500
C. -$1,150
D. -$520
E. none of the above
-$100 + [-$1,500(0.7)] = -$1,150.

Difficulty: Difficult

45. A portfolio consists of 800 shares of stock and 100 calls on that stock. If the hedge ratio
for the call is 0.5. What would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. +$700
B. -$850
C. -$580
D. -$520
E. none of the above
-$800 + [-$100(0.5)] = -$850.

Difficulty: Difficult

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46. A portfolio consists of 225 shares of stock and 300 calls on that stock. If the hedge ratio
for the call is 0.4, what would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. -$345
B. +$500
C. -$580
D. -$520
E. none of the above
-$225 + [-$300(0.4)] = -$345.

Difficulty: Difficult

47. A portfolio consists of 400 shares of stock and 200 calls on that stock. If the hedge ratio
for the call is 0.6, what would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. +$700
B. +$500
C. -$580
D. -$520
E. none of the above
-$400 + [-$200(0.6)] = -$520.

Difficulty: Difficult

48. If the hedge ratio for a stock call is 0.30, the hedge ratio for a put with the same expiration
date and exercise price as the call would be ________.
A. 0.70
B. 0.30
C. -0.70
D. -0.30
E. -.17
Call hedge ratio = N(d1); Put hedge ratio = N(d1) - 1; 0.3 - 1.0 = -0.7.

Difficulty: Difficult

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49. If the hedge ratio for a stock call is 0.50, the hedge ratio for a put with the same expiration
date and exercise price as the call would be ________.
A. 0.30
B. 0.50
C. -0.60
D. -0.50
E. -.17
Call hedge ratio = N(d1); Put hedge ratio = N(d1) - 1; 0.5 - 1.0 = -0.5.

Difficulty: Difficult

50. If the hedge ratio for a stock call is 0.60, the hedge ratio for a put with the same expiration
date and exercise price as the call would be _______.
A. 0.60
B. 0.40
C. -0.60
D. -0.40
E. -.17
Call hedge ratio = N(d1); Put hedge ratio = N(d1) - 1; 0.6 - 1.0 = -0.4.

Difficulty: Difficult

51. If the hedge ratio for a stock call is 0.70, the hedge ratio for a put with the same expiration
date and exercise price as the call would be _______.
A. 0.70
B. 0.30
C. -0.70
D. -0.30
E. -.17
Call hedge ratio = N(d1); Put hedge ratio = N(d1) - 1; 0.7 - 1.0 = -0.3.

Difficulty: Difficult

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52. A put option is currently selling for $6 with an exercise price of $50. If the hedge ratio for
the put is -0.30 and the stock is currently selling for $46, what is the elasticity of the put?
A. 2.76
B. 2.30
C. -7.67
D. -2.76
E. -2.30
% stock price change = ($47 - $46)/$46 = 0.021739; % option price change = $5.70 - $6.00)/
$6 = - 0.05; - 0.05/0.021739 = - 2.30.

Difficulty: Difficult

53. A put option on the S&P 500 index will best protect ________.
A. a portfolio of 100 shares of IBM stock.
B. a portfolio of 50 bonds.
C. a portfolio that corresponds to the S&P 500.
D. a portfolio of 50 shares of AT&T and 50 shares of Xerox stocks.
E. a portfolio that replicates the Dow.
The S&P 500 index is more like a portfolio that corresponds to the S&P 500 and thus is more
protective of such a portfolio than of any of the other assets.

Difficulty: Easy

54. Higher dividend payout policies have a __________ impact on the value of the call and a
__________ impact on the value of the put.
A. negative, negative
B. positive, positive
C. positive, negative
D. negative, positive
E. zero, zero
Dividends lower the expected stock price, and thus lower the current call option value and
increase the current put option value.

Difficulty: Moderate

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55. Lower dividend payout policies have a __________ impact on the value of the call and a
__________ impact on the value of the put.
A. negative, negative
B. positive, positive
C. positive, negative
D. negative, positive
E. zero, zero
Dividends lower the expected stock price, and thus lower the current call option value and
increase the current put option value.

Difficulty: Moderate

56. A one dollar decrease in a call option's exercise price would result in a(n) __________ in
the call option's value of __________ one dollar.
A. increase, more than
B. decrease, more than
C. decrease, less than
D. increase, less than
E. increase, exactly
Option prices are less than stock prices, thus changes in stock prices (market or exercise) are
greater (in absolute terms) than are changes in prices of options.

Difficulty: Moderate

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57. Which one of the following variables influence the value of call options?
I) Level of interest rates.
II) Time to expiration of the option.
III) Dividend yield of underlying stock.
IV) Stock price volatility.
A. I and IV only.
B. II and III only.
C. I, II, and IV only.
D. I, II, III, and IV.
E. I, II and III only.
All of the above variables affect call option prices.

Difficulty: Moderate

58. Which one of the following variables influence the value of put options?
I) Level of interest rates.
II) Time to expiration of the option.
III) Dividend yield of underlying stock.
IV) Stock price volatility.
A. I and IV only.
B. II and III only.
C. I, II, and IV only.
D. I, II, III, and IV.
E. I, II and III only.
All of the above variables affect put option prices.

Difficulty: Moderate

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59. An American call option buyer on a non-dividend paying stock will

A. always exercise the call as soon as it is in the money.
B. only exercise the call when the stock price exceeds the previous high
C. never exercise the call early.
D. buy an offsetting put whenever the stock price drops below the strike price.
E. none of the above.
An American call option buyer will not exercise early if the stock does not pay dividends;
exercising forfeits the time value. Rather, the option buyer will sell the option to collect both
the intrinsic value and the time value.

Difficulty: Moderate

60. Relative to European puts, otherwise identical American put options

A. are less valuable.
B. are more valuable.
C. are equal in value.
D. will always be exercised earlier.
E. none of the above.
It is valuable to exercise a put option early if the stock drops below a threshold price; thus
American puts should sell for more than European puts.

Difficulty: Moderate

61. Use the two-state put option value in this problem. SO = $100; X = $120; the two
possibilities for ST are $150 and $80. The range of P across the two states is _____; the hedge
ratio is _______.
A. $0 and $40; -4/7
B. $0 and $50; +4/7
C. $0 and $40; +4/7
D. $0 and $50; -4/7
E. $20 and $40; +1/2
When ST = $150; P = $0; when ST =$80: P = $40; ($0 - $40)/($150 - $80) = -4/7.

Difficulty: Difficult

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62. Use the Black-Scholes Option Pricing Model for the following problem. Given: SO = $70;
X = $70; T = 70 days; r = 0.06 annually (0.0001648 daily); = 0.020506 (daily). No dividends
will be paid before option expires. The value of the call option is _______.
A. $10.16.
B. $5.16.
C. $0.00.
D. $2.16.
E. none of the above.
d2 = 0.1530277 - (0.020506)(70)1/2 = -0.01853781; N(d1) = 0.5600; N(d2) = 0.4919; C =
0.5600($70) - $70[e-(0.0001648)(70)]0.4919 = $5.16.

Difficulty: Difficult

63. Empirical tests of the Black-Scholes option pricing model

A. show that the model generates values fairly close to the prices at which options trade.
B. show that the model tends to overvalue deep in the money calls and undervalue deep out of
the money calls.
C. indicate that the mispricing that does occur is due to the possible early exercise of
American options on dividend-paying stocks.
D. A and C.
E. A, B, and C.
Studies have shown that the model tends to undervalue deep in the money calls and to
overvalue deep out of the money calls. The other statements are true.

Difficulty: Difficult

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64. Options sellers who are delta-hedging would most likely

A. sell when markets are falling
B. buy when markets are rising
C. both A and B.
D. sell whether markets are falling or rising.
E. buy whether markets are falling or rising.
Options sellers who are delta-hedging would most likely sell when markets are falling and
buy when markets are rising.

Difficulty: Moderate

An American-style call option with six months to maturity has a strike price of $35. The
underlying stock now sells for $43. The call premium is $12.

65. What is the intrinsic value of the call?

A. $12
B. $8
C. $0
D. $23
E. none of the above.
43 - 35 = $8.

Difficulty: Easy

66. What is the time value of the call?

A. $8
B. $12
C. $0
D. $4
E. cannot be determined without more information.
12 - (43 - 35) = $4.

Difficulty: Moderate

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67. If the option has delta of .5, what is its elasticity?

A. 4.17
B. 2.32
C. 1.79
D. 0.5
E. 1.5
[(12.50 - 12)/12] / [(44 - 43)/43] = 1.79.

Difficulty: Difficult

68. If the risk-free rate is 6%, what should be the value of a put option on the same stock with
the same strike price and expiration date?
A. $3.00
B. $2.02
C. $12.00
D. $5.25
E. $8.00
P = 12 - 43 + 35/(1.06).5; P = $3.00

Difficulty: Difficult

69. If the company unexpectedly announces it will pay its first-ever dividend 3 months from
today, you would expect that
A. the call price would increase.
B. the call price would decrease.
C. the call price would not change.
D. the put price would decrease.
E. the put price would not change.
As an approximation, subtract the present value of the dividend from the stock price and
recompute the Black-Scholes value with this adjusted stock price. Since the stock price is
lower, the option value will be lower.

Difficulty: Moderate

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70. Since deltas change as stock values change, portfolio hedge ratios must be constantly
updated in active markets. This process is referred to as
A. portfolio insurance.
B. rebalancing.
C. option elasticity.
D. gamma hedging.
E. dynamic hedging.
Dynamic hedgers will convert equity into cash in market declines to adjust for changes in
option deltas.

Difficulty: Moderate

71. In volatile markets, dynamic hedging may be difficult to implement because

A. prices move too quickly for effective rebalancing.
B. as volatility increases, historical deltas are too low.
C. price quotes may be delayed so that correct hedge ratios cannot be computed.
D. volatile markets may cause trading halts.
E. all of the above.
All of the above correctly describe the problems associated with dynamic hedging in volatile
markets.

Difficulty: Easy

72. Rubinstein (1994) observed that the performance of the Black-Scholes model had
deteriorated in recent years, and he attributed this to
A. investor fears of another market crash.
B. higher than normal dividend payouts.
C. early exercise of American call options.
D. decreases in transaction costs.
E. none of the above.
Options on the same stock with the same strike price should have the same implied volatility,
but the exhibit progressively different implied volatilities. Rubinstein believes this is due to
fear of another market crash.

Difficulty: Moderate

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Chapter 21 - Option Valuation

73. The time value of a call option is

I) the difference between the option's price and the value it would have if it were expiring
immediately.
II) the same as the present value of the option's expected future cash flows.
III) the difference between the option's price and its expected future value.
IV) different from the usual time value of money concept.
A. I
B. I and II
C. II and III
D. II
E. I and IV
The time value of an option is described by I, and is different from the time value of money
concept frequently used in finance.

Difficulty: Easy

74. The time value of a put option is

I) the difference between the option's price and the value it would have if it were expiring
immediately.
II) the same as the present value of the option's expected future cash flows.
III) the difference between the option's price and its expected future value.
IV) different from the usual time value of money concept.
A. I
B. I and II
C. II and III
D. II
E. I and IV
The time value of an option is described by I, and is different from the time value of money
concept frequently used in finance.

Difficulty: Easy

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75. You purchased a call option for a premium of $4. The call has an exercise price of $29 and
is expiring today. The current stock price is $31. What would be your best course of action?
A. Exercise the call because the stock price is greater than the exercise price.
B. Do not exercise the call because the stock price is greater than the exercise price.
C. Do not exercise the call because the difference between the exercise price and the stock
price is not enough to cover the amount of the premium.
D. Exercise the call to get a positive net return on the investment.
E. Do not exercise the call to avoid a negative net return on the investment.
If you exercise the call, your return will be ($31 - 29 - 4)/$4 = -50%. But if you don't exercise
the call your return will be -$4/4 = -100%.

Difficulty: Moderate

76. As the underlying stock's price increased, the call option valuation function's slope
approaches
A. zero.
B. one.
C. two times the value of the stock.
D. one-half time s the value of the stock.
E. infinity
As the stock price increases the value of the call option increases in price one for one with the
stock price. The option is very likely to be exercised.

Difficulty: Moderate

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Chapter 21 - Option Valuation

77. Relative to non-dividend-paying European calls, otherwise identical American call

options
A. are less valuable.
B. are more valuable.
C. are equal in value.
D. will always be exercised earlier.
E. none of the above.
It never pays to exercise this call option before maturity. The holder of the call who wants to
close out the position would be better off selling the call because the value of the call must
exceed the potential proceeds from its exercise. Therefore the right to exercise the American
call early has no value and it should be equal in value to the European call.

Difficulty: Moderate

78. The Black-Scholes formula assumes that

I) the risk-free interest rate is constant over the life of the option.
II) the stock price volatility is constant over the life of the option.
III) the expected rate of return on the stock is constant over the life of the option.
IV) there will be no sudden extreme jumps in stock prices.
A. I and II
B. I and III
C. II and II
D. I, II and IV
E. I, II, III, and IV
The risk-free rate and stock price volatility are assumed to be constant but the option value
does not depend on the expected rate of return on the stock. The model also assumes that
stock prices will not jump markedly.

Difficulty: Difficult

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Chapter 21 - Option Valuation

79. Which Excel formula is used to execute the Black-Scholes option pricing model?
A. NORMAL
B. ABNORMAL
C. NORMSDIST
D. DIST
E. NORMALDIST
The textbook gives an example of how to use Excel to calculate some of the variables in the
model. See Figure 21.8.

Difficulty: Easy

80. The hedge ratio of an option is also called the options _______.
A. alpha
B. beta
C. sigma
D. delta
E. rho
The two terms mean the same thing.

Difficulty: Easy

81. Dollar movements in option prices are ________ than dollar movements in the stock
price, and rate of return volatility of options is ________ than stock return volatility.
A. less, less
B. greater, greater
C. less, greater
D. greater, less
E. There is no particular pattern.
Options cost less than the stock, so movements in their prices cause greater percentage
changes

Difficulty: Moderate

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Chapter 21 - Option Valuation

An American-style call option with six months to maturity has a strike price of $42. The
underlying stock now sells for $50. The call premium is $14.
82. What is the intrinsic value of the call?
A. $12
B. $10
C. $8
D. $23
E. none of the above.
50 - 42 = $8.

Difficulty: Easy

83. What is the time value of the call?

A. $8
B. $12
C. $6
D. $4
E. cannot be determined without more information.
14 - (50 - 42) = $6.

Difficulty: Moderate

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Chapter 21 - Option Valuation

84. If the company unexpectedly announces it will pay its first-ever dividend 4 months from
today, you would expect that
A. the call price would increase.
B. the call price would decrease.
C. the call price would not change.
D. the put price would decrease.
E. the put price would not change.
As an approximation, subtract the present value of the dividend from the stock price and
recompute the Black-Scholes value with this adjusted stock price. Since the stock price is
lower, the option value will be lower.

Difficulty: Moderate

Short Answer Questions

85. Discuss the relationship between option prices and time to expiration, volatility of the
underlying stocks, and the exercise price.
The longer the time to expiration, the higher the premium because it is more likely that an
option will become more valuable (more time for the stock price to change). The greater the
volatility of the underlying stock, the greater the option premium; the more volatile the stock,
the more likely it is that the option will become more valuable (e. g., move from an out of the
money to an in the money option, or become more in the money). For call options, the lower
the exercise price, the more valuable the option, as the option owner can buy the stock at a
lower price. For a put option, the lower the exercise price, the less valuable the option, as the
owner of the option may be required to sell the stock at a lower than market price.
Feedback: The purpose of this question is to insure that the student understands the
relationships of the variables that determine option prices, and the differences and similarities
of these variables on put and call option prices.

Difficulty: Moderate

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86. Which of the variables affecting option pricing is not directly observable? If this variable
is estimated to be higher or lower than the variable actually is how is the option valuation
affected?
The volatility of the underlying stock is not directly observable, but can be estimated from
historic data. If the implied volatility is lower than the actual volatility of the stock, the option
will be undervalued, as the higher the implied volatility, the higher the price of the option.
Investors often use the implied volatility of the stock, i.e., the volatility of the stock implied
by the price of the option. If investors think the actual volatility of the stock exceeds the
implied volatility, the option would be considered to be underpriced. If actual volatility
appears to be higher than the implied volatility, the "fair price" of the option would exceed the
actual price.
Feedback: The purpose of this question is to determine whether the student understands how
some investors use option pricing based on implied volatility to determine if the option
appears to be over or undervalued.

Difficulty: Difficult

87. What is an option hedge ratio? How does the hedge ratio for a call differ from that of a put
(or are the two equivalent)? Explain.
An option's hedge ratio is the change in the price of an option for a $1 increase in the stock
price. A call option has a positive hedge ratio; a put option has a negative hedge ratio. The
hedge ratio is the slope of the value function of the option evaluated at the current stock price.
Feedback: The purpose of this question is determine whether the student understands hedge
ratios and how these ratios vary for puts and calls.

Difficulty: Moderate

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88. You are evaluating a stock that is currently selling for $30 per share. Over the investment
period you think that the stock price might get as low as $25 or as high as $40. There is a call
option available on the stock with an exercise price of $35. Answer the following questions
about hedging your position in the stock. Assume that you will hold one share.
What is the hedge ratio?
How much would you borrow to purchase the stock?
What is the amount of your net investment in the stock?
Complete the table below to show the value of your stock portfolio at the end of the holding
period.

How many call options will you combine with the stock to construct the perfect hedge? Will
you buy the calls or sell the calls?
Show the option values in the table below.

Show the net payoff to your portfolio in the table below.

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Chapter 21 - Option Valuation

What must the price of one call option be?

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Chapter 21 - Option Valuation

The answers are shown below.

What is the hedge ratio? The hedge ratio equals the range of the call values divided by the
range of the stock values, which equals (5 - 0)/(40 - 25) = 1/3. [If the stock price ends at $40
the call is worth $5; if it ends at $25 the call is worth $0.]
How much would you borrow to purchase the stock? Borrow the present value of the
anticipated minimum stock price = $25/1.06 = $23.58
What is the amount of your net investment in the stock? The net amount of investment is $30
- 23.58 = $6.42.
Complete the table below to show the value of your stock portfolio at the end of the holding
period.

How many call options will you combine with the stock to construct the perfect hedge? Will
you buy the calls or sell the calls? Since the hedge ratio is 1/3 buy one stock and sell three call
options.
Show the option values in the table below.

Show the net payoff to your portfolio in the table below.

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Chapter 21 - Option Valuation

What must the price of one call option be? The value of the stock portfolio equals the value of
three calls. The net investment in the stock portfolio is $6.42 so this must equal the value of
the three calls. $6.42 = 3C, and C = $2.14. Alternatively, the value of the whole position must
equal the present value of the certain payoff: S - 3C = $23.58, $30 - 3C = $23.58, and C =
$2.14.
Feedback: This question tests the student's ability to construct a perfect hedge on a stock
portfolio using call options.
Difficulty: Difficult

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