Question 1

The option to abandon a project can decrease its value.

Accepted Answer

The option to abandon a project adds flexibility for the management to exit a project if it turns out to be unprofitable, thereby potentially limiting losses and increasing the overall value of the project.

Question 2

A call option can sometimes be priced higher than the underlying asset.

Accepted Answer

A call option gives the holder the right, but not the obligation, to buy an asset at a specified price (strike price) within a specific time period. The price of a call option is derived from various factors including the underlying asset's current price, time to expiration, volatility, and the risk-free interest rate, but it does not exceed the price of the underlying asset itself because its value is essentially a bet on the asset's future price increase. If it were priced higher than the asset, it would not be economically rational to buy the option instead of the asset directly.

Question 3

It is possible that some projects with a negative NPV should be pursued after taking into account the value of real options.

Accepted Answer

Real options refer to the flexibility to change or abandon a project in the future based on market conditions or other factors. Considering the value of real options can sometimes turn a project with a negative net present value (NPV) into a positive one. As a result, it is possible for projects with a negative NPV to be pursued after taking into account real options.

Question 4

The option to choose to terminate a project is like a put option.

Accepted Answer

A put option gives the holder the right, but not the obligation, to sell an underlying asset at a specified price within a specified period. In the same way, the option to terminate a project gives the decision-maker the right, but not the obligation, to end the project before completion.

Question 5

Suppose you have sold a put option on a stock with a strike price of $25 and the current price of the stock is $25. If the stock price at expiration is $30, your payoff will be -$5.

Accepted Answer

If the stock price at expiration is $30, the put option will expire worthless as it would not be beneficial for the holder to exercise the option to sell the stock at $25 when they can sell it in the market for $30. Therefore, as the seller of the put option, you would not have to pay anything, and your payoff would be the premium received for selling the option, not -$5.

Question 6

Consider a put option on a stock with a strike price of $60. If the stock price at expiration is $50, then the payoff from the put option is $10.

Accepted Answer

The payoff from a put option is calculated as the difference between the strike price and the stock price at expiration, only if this difference is positive. So in this case, the payoff from the put option would be $10, which is the difference between the strike price of $60 and the stock price of $50.

Question 7

In the binomial pricing model, an option is priced using a replicating portfolio that typically consists of a risk-free bond and the asset underlying the option.

Accepted Answer

This is true. The binomial pricing model involves creating a replicating portfolio consisting of the underlying asset and a risk-free bond in order to price an option.

Question 8

The option to defer investment can be characterized as the flexibility to wait and learn more information about a project before committing resources to the project.

Accepted Answer

The statement accurately describes the option to defer investment.

Question 9

To price an option using the binomial pricing model, it is important that we know the probability that the asset will increase in value.

Accepted Answer

The binomial pricing model uses risk-neutral probabilities, which do not require the actual probability of the asset increasing in value. Instead, it relies on the risk-free rate and the potential up and down movements of the asset.

Question 10

A stock is selling for $50 today. A call option on the stock with a strike price of $50 is set to expire next month. If the price of the stock goes down tomorrow, we would expect the price of the call option to go down as well.

Accepted Answer

The price of a call option is directly related to the price of the underlying stock. If the price of the stock goes down, the value of the call option decreases as well, because there is less chance of the stock price going above the strike price. As a result, we would expect the price of the call option to go down too.

Question 11

If a firm adds financial options to its debt securities, it will increase the interest expense to the firm.

Accepted Answer

The answer of If a firm adds financial options to...

Question 12

If the risk-free rate of interest increases, all else being equal, we would expect the value of a call option to increase.

Accepted Answer

An increase in the risk-free rate of interest would increase the time value component of the option price, which in turn would increase the value of the call option. This happens because a rise in the risk-free rate increases the cost of carrying the underlying asset and reduces the present value of the exercise price, both of which benefit the holder of a call option.

Question 13

The current price of an asset is $75. A put option on the asset with a strike price of $100 expires one year from now. It is possible, without arbitrage, for this put option to be priced at $24 today.

Accepted Answer

The intrinsic value of the put option is the difference between the strike price ($100) and the current price of the asset ($75), which is $25. However, the actual price of the option also includes time value, which accounts for the possibility of the asset price decreasing further. Therefore, a price of $24, slightly below the intrinsic value, is possible due to factors like time value, volatility, and interest rates.

Question 14

When using the binomial pricing model to price an option, the volatility of the underlying asset's value is represented by the difference between the two possible future values of the underlying asset.

Accepted Answer

In the binomial pricing model, the volatility of the underlying asset's value is represented by the standard deviation of the possible future values of the underlying asset, which is calculated using the difference between the two possible future values.

Question 15

A put option with a strike price of $20 is expiring today. The stock is currently selling at $25. Based on this information, the put option should not be exercised.

Accepted Answer

A put option gives the holder the right to sell a stock at a specified price (strike price). If the stock's current market price is higher than the strike price, as in this case ($25 vs. $20), exercising the option would mean selling the stock for less than its market value, which is not financially beneficial.

Question 16

If a project has a positive NPV, then the real options that are relevant to the project are not important to estimating the value of the project.

Accepted Answer

If a project has a positive NPV, it still may be valuable to consider real options that could increase the value of the project even further. Real options refer to additional opportunities or choices that a project may have in the future, such as expanding the project, delaying it, or abandoning it if necessary. Considering these options can often lead to a more accurate estimation of the project's value and help managers make better decisions. Therefore, real options should be taken into account even if the NPV is positive.

Question 17

A portfolio consisting of one put option and one call option, both with the same exercise price, is a good investment strategy for investors who don't know whether an asset's value is likely to go up or down but think that the volatility of the asset will increase.

Accepted Answer

By buying both a put option and a call option with the same exercise price, the investor is essentially creating a synthetic long or short position in the underlying asset. If the asset's value goes up, the call option will generate profits, while the put option will expire worthless. Conversely, if the asset's value goes down, the put option will generate profits, while the call option will expire worthless. By holding both options, the investor can profit from any movement in the asset's price. Additionally, if the volatility of the asset increases, the value of both options will also increase, potentially leading to higher profits. Therefore, this strategy can be a good investment for investors who want to capitalize on an increase in volatility without knowing which direction the asset will move.

Question 18

Consider a call option on a stock with a strike price of $60. If the stock price at expiration is $50, then the payoff from the call option is $10.

Accepted Answer

The payoff from a call option with a strike price of $60 when the stock price at expiration is $50 is $0, not $10. The owner of the call option would not exercise it since it would be cheaper to buy the stock on the market for $50 rather than exercising the option at a higher price of $60.

Question 19

A company is negotiating for the option to develop a platinum mine. Under the terms of the option contract, the company would be able to purchase the development rights to the mine one year from now for an exercise price specified today. If, during the negotiations over the option contract, the volatility of the price of platinum increases, the company should expect to pay a higher price for the development option.

Accepted Answer

An increase in volatility generally leads to an increase in option prices, as there is a higher probability of the underlying asset (in this case, platinum) fluctuating in value, which increases the potential payoff for the option holder. Therefore, the company should expect to pay a higher price for the development option if the volatility of the price of platinum increases during negotiations.

Question 20

Neither a call nor a put option can have a negative price.

Accepted Answer

This statement is true because the price of an option cannot be negative. The lowest possible price for an option is zero, which means that the option has no value. If the underlying asset of the option has no value, then the option also has no value. However, if the underlying asset has some positive value, then the option must also have a positive value or price.

Quiz 20: Options and Corporate Finance