Chapter 8 iClickers

Multiple Choice Identify the choice that best completes the statement or answers the question. ____ 1. An option that gives the holder the right to sell a stock at a specified price at some future time is a. a call option. b. a put option. c. an out-of-the-money option. d. a naked option. e. a covered option. 2. Call options on XYZ Corporation's common stock trade in the market. Which of the following statements is most correct, holding other things constant? a. The price of these call options is likely to rise if XYZ's stock price rises. b. The higher the strike price on XYZ's options, the higher the option's price will be. c. Assuming the same strike price, an XYZ call option that expires in one month will sell at a higher price than one that expires in three months. d. If XYZ's stock price stabilizes (becomes less volatile), then the price of its options will increase. e. If XYZ pays a dividend, then its option holders will not receive a cash payment, but the strike price of the option will be reduced by the amount of the dividend. 3. GCC Corporation is planning to issue options to its key employees, and it is now discussing the terms to be set on those options. Which of the following actions would decrease the value of the options, other things held constant? a. GCC's stock price suddenly increases. b. The exercise price of the option is increased. c. The life of the option is increased, i.e., the time until it expires is lengthened. d. The Federal Reserve takes actions that increase the risk-free rate. e. GCC's stock price becomes more risky (higher variance). 4. Which of the following statements is CORRECT? a. Put options give investors the right to buy a stock at a certain strike price before a specified date. b. Call options give investors the right to sell a stock at a certain strike price before a specified date. c. Options typically sell for less than their exercise value. d. LEAPS are very short-term options that were created relatively recently and now trade in the market. e. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend. 5. Deeble Construction Co.'s stock is trading at $30 a share. Call options on the company's stock are also available, some with a strike price of $25 and some with a strike price of $35. Both options expire in three months. Which of the following best describes the value of these options? a. The options with the $25 strike price will sell for $5. b. The options with the $25 strike price will sell for less than the options with the $35 strike price. c. The options with the $25 strike price have an exercise value greater than $5. d. The options with the $35 strike price have an exercise value greater than $0.

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e. If Deeble's stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5. ____ 6. Which of the following statements is CORRECT? a. If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit. b. Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be. c. Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be. d. Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be. e. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock. 7. Suppose you believe that Johnson Company's stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $310.25 you can buy a 5-month call option giving you the right to buy 100 shares at a price of $25 per share. If you buy this option for $310.25 and Johnson's stock price actually rises to $45, what would your pre-tax net profit be? a. $310.25 b. $1,689.75 c. $1,774.24 d. $1,862.95 e. $1,956.10 8. Suppose you believe that Delva Corporation's stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put option giving you the right to sell 100 shares at a price of $85 per share. If you bought this option for $510.25 and Delva's stock price actually dropped to $60, what would your pre-tax net profit be? a. $510.25 b. $1,989.75 c. $2,089.24 d. $2,193.70 e. $2,303.38 9. The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option's value? a. $2.43 b. $2.70 c. $2.99 d. $3.29 e. $3.62

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____ 10. An analyst wants to use the Black-Scholes model to value call options on the stock of Ledbetter Inc. based on the following data: The price of the stock is $40. The strike price of the option is $40. The option matures in 3 months (t = 0.25). The standard deviation of the stock's returns is 0.40, and the variance is 0.16.

The risk-free rate is 6%.

Given this information, the analyst then calculated the following necessary components of the Black-Scholes model: d1 = 0.175 d2 = 0.025 N(d1) = 0.56946 N(d2) = 0.49003

N(d1) and N(d2) represent areas under a standard normal distribution function. Using the Black-Scholes model, what is the value of the call option? a. $2.81 b. $3.12 c. $3.47 d. $3.82 e. $4.20

Chapter 8 iClickers Answer Section

MULTIPLE CHOICE 1. ANS: B PTS: 1 DIF: Easy OBJ: 8.1 NAT: AACSB: C; P TOP: Option terms MSC: Conceptual 2. ANS: A PTS: 1 DIF: Easy OBJ: 8.1 NAT: AACSB: C; P TOP: Option concepts MSC: Conceptual 3. ANS: B PTS: 1 DIF: Easy OBJ: 8.1 NAT: AACSB: C; P TOP: Option concepts MSC: Conceptual 4. ANS: E PTS: 1 DIF: Easy OBJ: Comp: 8.1 | Comp: 8.3 | Comp: 8.4 NAT: AACSB: C; P TOP: Miscellaneous option concepts MSC: Conceptual 5. ANS: E PTS: 1 DIF: Medium OBJ: 8.1 NAT: AACSB: C; P TOP: Option value MSC: Conceptual 6. ANS: A PTS: 1 DIF: Medium OBJ: Comp: 8.1 | Comp: 8.5 | Comp: 8.6 NAT: AACSB: C; P TOP: Miscellaneous option concepts MSC: Conceptual 7. ANS: B The call option will be exercised only if the final price is above the strike price. If the final price is below the strike price, there will simply be a loss equal to the cost of the option. Strike price: $25.00 Final price: $45.00 No. of options: 100 Option cost: $310.25

Profit per share = Final price Strike price = $45 $25 or zero: $20.00 Total profit = Profit/option No. of options Cost of options = $1,689.75 PTS: 1 DIF: Easy OBJ: 8.1 NAT: AACSB: C; P TOP: Call options MSC: Problem 8. ANS: B The put option will be exercised only if the final price is below the strike price. If the final price exceeds the strike price, there will simply be a loss equal to the cost of the option. Strike price: $85.00 Final price: $60.00 No. of options: 100 Option cost: $510.25

Profit per share = Strike price Final price = $85 $60 or zero: $25.00 Total profit = Profit/option No. of options Cost of options = $1,989.75 PTS: 1 TOP: Put options 9. ANS: C Current price DIF: Easy MSC: Problem OBJ: 8.1 NAT: AACSB: C; P

$22.00 Price at end of year:

Exercise price rRF Step 1. Step 2. Payoff range, stock: Payoff range, option: If stock is high: If stock is low: Option range:

$22.00 High 6.00% Low $27.00 $17.00 = Price Exercise = 27 22 = (Price Exercise) or $0 = $5 $0 =

$27.00 $17.00 $10.00

$ 5.00 0.00 $ 5.00

Step 3.

Equalize the ranges to find the number of shares of stock: Option range/Stock range = $5/$10 = shares of stock =

0.5

Step 4.

The payoff from 0.5 shares of stock will be either: $13.50 or $ 8.50 The payoff from the option will be either: 5.00 or 0.00 The portfolio's payoff will be either: $ 8.50 or $ 8.50 So the portfolio's payoff is riskless, $8.50 regardless of which choice materializes. The present value of $8.50 at the daily compounded risk-free rate is: PV = $8.50/(1 + (0.06/365)) 365 = $8.005. The option price is the cost of the stock purchased for the portfolio minus the PV of the payoff: V = 0.5($22) $8.01 = $2.99

Step 5.

Step 6.

PTS: 1 DIF: Medium OBJ: 8.2 NAT: AACSB: C; P TOP: Option price based on binomial model MSC: Problem 10. ANS: C Stock price: $40.00 N(d1) = 0.56946 Strike price: $40.00 N(d2) = 0.49003 Option maturity: 0.25 Variance of stock returns: 0.16 Risk-free rate: 6.0% The Black-Scholes model calculates the value of the call option as: V = P[N(d1)] Xert[N(d2)] = $40(0.56946) $40ert(0.49003) = $22.78 $19.31 = $3.47 PTS: 1 DIF: Hard TOP: Black-Scholes model OBJ: 8.5 MSC: Problem NAT: AACSB: C; P