Deck 19: Financial Options and Applications in Corporate Finance

Question 1

Because of the time value of money, the longer before an option expires, the less valuable the option will be, other things held constant.

Answer 1

False

Question 2

An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified period of time.

Answer 2

True

Question 3

If we define the "premium" on an option to be the difference between the price at which an option sells and the exercise value (or the difference between the stock's current market price and the strike price), then we would expect the premium to increase as the stock price increases, other things held constant.

Answer 3

False

Question 4

Call options on XYZ Corporation's common stock trade in the market. Which of the following statements best describes the options, other things held 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 1 month will sell at a higher price than one that expires in 3 months.
D) If XYZ's stock price stabilizes (becomes less volatile), then the price of its options will increase.

Question 5

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, provided the strike prices for the put and call are the same.

Question 6

What is an option that gives the holder the right to sell a stock at a specified price at some future time?

A) a call option
B) a put option
C) a naked option
D) a covered option

Question 7

An investor who writes standard call options against stock held in his or her portfolio is said to be selling what type of options?

A) in-the-money
B) naked
C) covered
D) out-of-the-money

Question 8

The exercise value of a call option is the positive difference between the current price of the stock and the strike price. The exercise value is zero if the stock's price is below the strike price.

Question 9

Warner Motors' stock is trading at $20 a share. Call options that expire in three months with a strike price of $20 sell for $1.50. Which of the following will occur if the stock price increases 10%, to $22 a share?

A) The price of the call option will increase by $2.
B) The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%.
C) The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%.
D) The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%.

Question 10

The strike price is the price that must be paid for a common share when it is bought by exercising a warrant.

Question 11

If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero value.

Question 12

As the price of a stock rises above the strike price, the value investors are willing to pay for a call option increases because (1) the immediate capital gain that can be realized by exercising the option and (2) the likely exercise value of the option when it expires have both increased.

Question 13

Other things held constant, the value of an option depends on the stock's price, the risk-free rate, and what else?

A) the strike price
B) the variability of the stock price
C) the option's time to maturity
D) the strike price; the variability of the stock price; and the option's time to maturity

Question 14

If a company announces a change in its dividend policy from a zero target payout ratio to a 100% payout policy, this action could be expected to increase the value of long-term options (say 5-year options) on the firm's stock.

Question 15

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) LEAPS are very short-term options that were created relatively recently and now trade in the market.
D) An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend.

Question 16

Since investors tend to dislike risk and like certainty, the more volatile a stock, the less valuable will be an option to purchase the stock, other things held constant.

Question 17

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 becomes more risky (higher variance).
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 government takes actions that increase the risk-free rate.

Question 18

If the market is in equilibrium, then a call option contract must sell at a price that is exactly equal to the difference between the stock's current price and the option's strike price.

Question 19

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 3 months. Which of the following best describes the value of these options?

A) The options with the $25 strike price will sell for less than the options with the $35 strike price.
B) The options with the $25 strike price have an exercise value greater than $5.
C) The options with the $35 strike price have an exercise value greater than $0.
D) If Deeble='s stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5.

Question 20

The exercise value is also called the strike price, but this term is generally used when discussing convertibles rather than financial options.

Question 21

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

Question 22

Which of the following statements best describes options?

A) An option's value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option can't sell for more than its exercise value.
B) As the stock's price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases.
C) The market value of an option depends in part on the option's time to maturity and also on the variability of the underlying stock's price.
D) The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger.

Question 23

The current price of a stock is $22, and at the end of 1 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

Question 24

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

Question 25

Which of the following statements is correct?

A) Call options generally sell at a price less than their exercise value.
B) If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value.
C) Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, the lower the premium on the option is likely to be.
D) 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.

Question 26

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.

Question 27

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. What is the value of the call option?

A) $2.81
B) $3.12
C) $3.47
D) $3.82

Question 28

The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $55 sells for $7.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option?

A) $7.71
B) $8.12
C) $8.55
D) $9.00