Deck 18: Option Valuation and Strategies

Question 1

The "collar strategy" is used to lock-in profits from an increase in the price of a stock.

Answer 1

True

Question 2

The hedge ratio indicates the number of call options that is necessary to offset price movements in the underlying stock.

Answer 2

True

Question 3

To construct a bear spread, the investor buys a call option and shorts the stock.

Answer 3

False

Question 4

The Black/Scholes option valuation model divides the option's strike price by the probability that the option will be exercised.

Question 5

The hedge ratio is one piece of information given by the Black/Scholes option valuation model.

Question 6

Buying a call and a treasury bill produces similar results as buying a stock and a put.

Question 7

If an individual sells a stock short, that investor is protected from a large increase in the price of the stock by selling a call option.

Question 8

If the hedge ratio is 0.7, the number of call options necessary to offset a long position in a stock is 7.0.

Question 9

The protective call strategy is an illustration of a short position.

Question 10

According to the Black/Scholes option valuation model, the value of a call option rises as interest rates increase.

Question 11

An investor buys a straddle in anticipation of stable stock prices.

Question 12

If investors believe that a stock's price will fluctuate but they are not certain as to the direction, these investors may buy a straddle.

Question 13

Selling a call and purchasing a treasury bill produces the same returns as buying a stock.

Question 14

According to the Black/Scholes option valuation model, the value of a call option rises as it approaches expiration.

Question 15

Put-call parity explains why a change in interest rates by the Federal Reserve affects stock and option prices.

Question 16

Put-call parity suggests that the sum of the prices of a stock, a call and a put on that stock, and a debt instrument maturing at the expiration of the options must equal zero.

Question 17

Bull and Bear spreads require taking a long position in one option and a short position in another option with a different strike price.

Question 18

Writing both a put and a call at the same strike price and expiration date is an illustration of a straddle.

Question 19

An investor cannot buy and sell two different call options with the same expiration dates.

Question 20

According to put-call parity, if a stock is overpriced, the investor should sell the stock short, sell the put, buy the call, and buy the bond.

Question 21

According to the Black/Scholes option valuation model, a call option's value decreases if

A)interest rates increase as the option approaches expiration
B)the variability of the stock's return decline and the interest rate decreases
C)an increase in the price of the stock results in a two for one stock split
D)the option is exercised

Question 22

Put-call parity suggests that

A)the sum of the prices of a stock and a call equal zero
B)the sum of the prices of a put and a call equal zero
C)the sum of the prices of a stock, a call, a put, and a bond equal zero
D)sum of the prices of a stock and a put must equal the sum of the prices of a call and a discounted bond with the maturity date as the expiration date of the options

Question 23

An investor owns 1,000 shares of stock but anticipates its price may decline. To reduce the risk of loss, how many call options must be sold if the hedge ratio is 0.7?

Question 24

Put-call parity basically says that combination of a put, a call, and a risk-free bond must be the same value as the underlying stock. If not, at least one market is in disequilibrium. The resulting arbitrage alters the securities' prices until the value of the call plus the bond is equal to the prices of the put plus the stock. Currently, the price of a stock is $100 while the price of a call option at $100 is $10; the price of the put option is $4.59, and the rate of interest is 8 percent, so that the investor may purchase a $100 discounted note for $92.59.
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a. Do these prices indicate that the financial markets are in equilibrium? Show all calculations.
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b. An arbitrage opportunity exists, but if the position is set up incorrectly, losses will be sustained. Verify that a loss will be sustained if the arbitrage is set up incorrectly. Calculate the results based on stock prices of $80, $100, and $120 as of the expiration date of the options.

Question 25

The price of a stock is $46 and the prices of call options to buy the stock at $45 and $50 are $6 and $3, respectively. What are the potential profits and losses when the price of the stock is $40, $45, $50, and $55 if the investor buys the call at $45 and sells the call at $50?

Question 26

According to the Black/Scholes option valuation model, the value of a call option increases if

A)the option approaches expiration
B)the return on the stock is more certain
C)interest rates on a discounted bond decline
D)the standard deviation of the stock's return increases

Question 27

Put-call parity asserts that a combination of a long position in the stock and the put produces the same return as a comparable position in a call and a risk-free bond. If not, at least one market is in disequilibrium. The resulting arbitrage alters the securities' prices until the value of the stock plus the put equals the prices of the call and the bond. The successful use of arbitrage assumes the investor of a profit no matter what happens to the price of the stock.

Put-call parity also asserts that if an arbitrage opportunity does not exist, then a combination of the stock and the put produces the same return as the comparable position in the call and the risk-free bond. Currently, the price of a stock is $70 while the price of a call option at $70 is $6; the price of the put option at $70 is $2, and the price of a discounted bond is $66. Verify that a long position in the stock and the put produces the same performance as a long position in the call and the bond for the following prices of the stock: $60, 65, 70, 75, and 80.

Question 28

If the investor buys a bull spread, the individual anticipates

A)higher call price
B)higher stock prices
C)lower stock prices
D)lower call prices

Question 29

If a stock is selling for $33 and the price is not expected to fluctuate, what are the potential profits and losses from writing a straddle if a call option at $35 sells for $3 and the put option at $35 sells for $4?

Question 30

If an investor sells a stock short, that individual reduces the risk of loss by

A)buying a put
B)buying a call
C)entering a limit order to sell the stock if its price declines
D)increasing the collateral with the broker

Question 31

An increase in the VIX is associated with

A)increased stock returns
B)increased stock market volatility
C)increased interest rates
D)increased market complacency

Question 32

If the investor buys a bear spread, the individual anticipates

A)higher interest rates
B)higher option prices
C)lower stock prices
D)lower put prices

Question 33

A call option exists to buy a stock at $25 a share. According to the Black/Scholes option valuation model, what is the value of the call
a. if the price of the stock is $25, the interest rate is 8 percent, the option expires in three months, and the standard deviation of the stock's return is 0.20 (20 percent)?
b. if the price of the stock is $25, the interest rate is 6 percent, the option expires in three months, and the standard deviation of the stock's return is 0.20 (20 percent)?
c. if the price of the stock is $27, the interest rate is 8 percent, the option expires in three months, and the standard deviation of the stock's return is 0.20 (20 percent)?

Question 34

The VIX is

A)an index of option prices
B)an index of Black/Scholes option values
C)positively correlated with the S&P 500
D)a measure of investor sentiment

Question 35

If the investor anticipates that the price of stock will be stable, he or she may

A)sell a straddle
B)buy a straddle
C)buy a call
D)buy a put

Question 36

If a call is overvalued, put-call parity suggests that the investor should

A)sell the call and the stock and buy the put and the bond
B)sell the call and the bond and buy the put and the stock
C)sell the bond and the put and buy the stock and the call
D)sell the stock and the put and buy the call and the bond

Question 37

If the investor anticipates that the price of a stock will fluctuate, this individual may

A)sell a call and sell a put
B)buy a call and buy a put
C)buy a call and sell a put
D)sell a call and buy a put

Question 38

To acquire a straddle, the investor

A)buys stock and a call
B)buys two calls with different strike prices
C)buys a put and sells a call with the same strike price
D)buys a put and buys a call with the same strike price

Question 39

According to the Black/Scholes option valuation model, a call option's value increases if

A)stock prices increase and interest rates decrease
B)the time to expiration decreases and interest rates increase
C)the variability of the stock's return increases and stock prices increase
D)interest rates decrease and the variability of the stock's return increases

Question 40

The hedge ratio determines

A)the number of call options to offset movements in the price of the stock
B)the number of call options to offset a straddle
C)the number of put options to offset movements in the price of a call option
D)the number of call options to offset the impact of changes in interest rates