Question 1

Which one of the following statements is NOT true?

Accepted Answer

Option A is true as the buyer of a call option has the right but not the obligation to buy the underlying asset at the strike price, hence the value of the option can never go negative. Option B is also true as the maximum value a call option can have is when the stock price equals or exceeds the strike price (at expiration), hence the value of the call option cannot be more than the stock price. Option C is true as the option buyer would not exercise the option if it were worth less than the asset price minus the present value of the strike price. However, option D is incorrect as in certain situations such as deep in-the-money, a call option can be worth more than the strike price.

Question 2

Consider a company that is likely to go bankrupt in the next year. The bondholders may encourage the company to pursue risky negative-NPV projects in hopes that the company will avoid financial distress.

Accepted Answer

Bondholders typically prefer less risky projects to ensure they receive their payments, as they have a fixed claim on the company's assets. Risky projects increase the chance of default, which is not in the bondholders' interest.

Question 3

Kingswood Motor Co. has a defined-benefit pension plan for its employees. To fund the plan, the company makes periodic contributions to a share investment fund. If the share market declines significantly, the company would have to make additional contributions to make up for lost revenue. The company could hedge its risk of a market downturn by periodically purchasing put options on the share market.

Accepted Answer

By purchasing put options, Kingswood Motor Co. would have the right to sell their shares at a set price even if the market declines, providing a form of insurance against market downturns. This would help hedge their risk and potentially reduce the need for additional contributions to the pension plan.

Question 4

A local city government has awarded a contract to sequentially build five new elementary schools over the next 10 years. The price for each school has been spelled out in the contract, but at the beginning of each year the city can cancel the order for the remaining schools. The city government is concerned that if the population of the town does not grow as expected it may not need all of the schools. What sort of financial option does the option to cancel the order resemble?

Accepted Answer

The answer of A local city government has awarded a...

Question 5

Hedging is the process of using financial instruments such as options, forwards, futures, and swaps to reduce the financial risks faced by a company.

Accepted Answer

Hedging involves using financial instruments to mitigate risks, so the statement is true.

Question 6

A small soybean farmer wants to hedge the price risk of his next crop, but he is financially constrained. He can't raise capital by either borrowing money or selling his current assets. Instead, he sells call options on his soybean crop with a strike price of $14 per bushel at a premium of $0.50 a bushel. Using the process from selling the call options, he buys put options on his soybean crop with a strike price of $11.00 per bushel at a premium of $0.35 per bushel. The risk-free interest rate is 0 per cent. By taking these derivative positions, the farmer has guaranteed that he will earn somewhere between $14.15 and $11.15 per bushel.

Accepted Answer

By selling call options at a strike price of $14 and buying put options at a strike price of $11, the farmer has established a price range of $14.15 to $11.15 per bushel, which provides him with a guaranteed minimum and maximum price for his crop. The premiums earned from selling the call options and paying for the put options will offset each other to some extent but may not entirely cancel out. However, the net cost of the options will be lower than the capital required for a futures contract or other hedging strategies, which makes this approach attractive for financially constrained farmers.

Question 7

Suppose the current spot price of wheat is $25 a bushel. A wheat farmer expects to produce 1,000 bushels at the end of the season, and she wants to ensure that she gets at least $19 a bushel. If a put option on 1,000 bushels of wheat with a strike price of $20,000 and an expiration date at the end of the season is selling for $1,000, the farmer can purchase the put option to guarantee she gets $19 a bushel.

Accepted Answer

By purchasing the put option, the wheat farmer can exercise the option at the end of the season to sell 1,000 bushels of wheat at the strike price of $20 a bushel for a guaranteed minimum income of $19,000 ($19 x 1,000). The cost of the put option is $1,000, which is the premium paid for the right to exercise the option. Therefore, the farmer can ensure a minimum price of $19 a bushel for her wheat and protect herself against potential decreases in the spot price of wheat.

Question 8

Which one of the following statements is NOT true?

Accepted Answer

The answer of Which one of the following statements is...

Question 9

Consider an option that gives the owner the right to buy a share for $20 only on the third Friday of May, next year. The option being described is:

Accepted Answer

This is a European call option, as it can only be exercised on a specific date (third Friday of May next year). An American option would allow the holder to exercise at any time up until the expiration date, while a put option would give the holder the right to sell a share at a specified price.

Question 10

Financial options can be used to hedge risks such as interest rates and foreign exchange rates.

Accepted Answer

Financial options such as interest rate options and currency options can be used to hedge against risks related to interest rates and foreign exchange rates.

Question 11

Option pay-offs: What is the pay-off for a call option with a strike price of $30 if the underlying share price at expiration is $25?

Accepted Answer

The underlying share price at expiration is below the strike price of the call option, so it is not profitable to exercise the option. The best choice is not to exercise the option and let it expire worthless.

Question 12

An investor (the buyer) purchases a put option from a seller. On the expiration date of a call option:

Accepted Answer

A put option gives the buyer the right to sell the underlying asset at a predetermined price to the seller. On the expiration date, the buyer has the right to sell the asset and the seller has the obligation to buy it. Therefore, choice C is the correct answer.

Question 13

By designing compensation plans with performance bonuses, share-based compensation and share options corporate boards are attempting to make the pay-off function for managers look similar to the pay-off function for shareholders.

Accepted Answer

By incorporating performance bonuses, share-based compensation, and share options into compensation plans, corporate boards aim to align the interests of managers and shareholders by making their pay-offs similar. This is done to encourage managers to make decisions that will increase the value of the company, thereby benefiting both the shareholders and themselves.

Question 14

New Wave Homes is a developer of planned residential communities. It has entered into an option contract with a land owner outside Sydney, NSW. It will pay the land owner $100,000 for the option to buy the land in two years at a price of $20 million. During that time New Wave will evaluate population and real estate trends in Sydney. Their plan is to buy the land if real estate prices in Sydney increase enough that developing the land would be worth more than the $20 million price. The $20 million purchase price resembles:

Accepted Answer

The $20 million purchase price is the strike price of a call option on the land, as it is the price at which New Wave Homes can buy the land in the future.

Question 15

Suppose you own a call option on a share with a strike price of $20 that expires today. The price of the underlying share is $15. If you exercise the option and immediately sell the share:

Accepted Answer

Exercising the option and immediately selling the share at the current market price of $15 will result in a loss of $5 ($20 strike price - $15 market price). Therefore, the best choice would be to not exercise the option and let it expire worthless.

Question 16

An investor (the buyer) purchases a call option from a seller. On the expiration date of a call option:

Accepted Answer

On the expiration date of a call option, the buyer has the right to buy the underlying asset at the strike price specified in the option contract. The seller, on the other hand, has the obligation to sell the underlying asset to the buyer if the buyer decides to exercise the option. Therefore, the correct choice is B.

Question 17

Option pay-offs: What is the pay-off for a call option with a strike price of $45 if the underlying share price at expiration is $75?

Accepted Answer

The pay-off for a call option is calculated as the difference between the underlying share price at expiration and the strike price. In this case, $75 - $45 = $30.

Question 18

Suppose you own a put option on a share with a strike price of $35 that expires today. The price of the underlying share is $25. If you purchase the share and exercise the put option:

Accepted Answer

If you purchase the share at $25 and exercise the put option with a strike price of $35, you have the right to sell the share at $35. Since the market price of the share is only $25, you would make a profit of $10 by selling it at the higher price. Therefore, you will earn $10.

Question 19

Consider an American and a European call option on a dividend-paying share, with otherwise identical features (same strike price, etc.). Which one of the following statements is true?

Accepted Answer

The American call option can be exercised at any time before expiration, while the European call option can only be exercised at expiration. This gives the American call option more flexibility, which makes it more valuable than the European call option.

Question 20

Suppose the current spot price of corn is $20 a bushel. A corn farmer expects to produce 2,000 bushels at the end of the season, and she wants to ensure that she gets at least $18 per bushel. Call options on 1,000 bushels of wheat with a strike price of $15,000 and an expiration date at the end of the season are selling for $3,000. By selling call options on her corn crop, the farmer can guarantee that she gets at least $18 per bushel.

Accepted Answer

Selling call options on wheat will not help the corn farmer guarantee a minimum price for her corn crop. She would need to sell call options on her own corn crop to achieve this goal.

Quiz 20: Options and Corporate Finance

Which one of the following statements is NOT true?

Consider a company that is likely to go bankrupt in the next year. The bondholders may encourage the company to pursue risky negative-NPV projects in hopes that the company will avoid financial distress.

Hedging is the process of using financial instruments such as options, forwards, futures, and swaps to reduce the financial risks faced by a company.

Which one of the following statements is NOT true?

Consider an option that gives the owner the right to buy a share for $20 only on the third Friday of May, next year. The option being described is:

Financial options can be used to hedge risks such as interest rates and foreign exchange rates.

Option pay-offs: What is the pay-off for a call option with a strike price of $30 if the underlying share price at expiration is $25?

An investor (the buyer) purchases a put option from a seller. On the expiration date of a call option:

By designing compensation plans with performance bonuses, share-based compensation and share options corporate boards are attempting to make the pay-off function for managers look similar to the pay-off function for shareholders.

Suppose you own a call option on a share with a strike price of $20 that expires today. The price of the underlying share is $15. If you exercise the option and immediately sell the share:

An investor (the buyer) purchases a call option from a seller. On the expiration date of a call option:

Option pay-offs: What is the pay-off for a call option with a strike price of $45 if the underlying share price at expiration is $75?

Suppose you own a put option on a share with a strike price of $35 that expires today. The price of the underlying share is $25. If you purchase the share and exercise the put option:

Consider an American and a European call option on a dividend-paying share, with otherwise identical features (same strike price, etc.) . Which one of the following statements is true?