You own a share of common stock in Vibrapower, Inc., which is currently trading for $18 and will either rise to $30 or fall to $12 in one year. Assume the risk-free rate for one year is 0 percent. You also own an American put option on the stock with a strike price of $20, which expires in one year. What is the value of the put option, and what would be the net payoff from exercising the option now? (Do not round intermediate computations. Round final answer to two decimal places.)

Question

Quizplus · Accepted Answer

To calculate the value of the put option, we use the maximum between the strike price and the stock price minus the strike price. In this case, the maximum is $20 - $18 = $2. Therefore, the value of the put option is $2.

If we exercise the option now, we can sell the stock for $18 and receive $20 from the put option, for a total of $38. However, if we wait until the end of the year, the stock will either be worth $30 or $12. If it is worth $30, we can sell it for $30 and receive nothing from the option. If it is worth $12, we can sell it for $12 and receive $20 from the option, for a total of $32.

Therefore, the net payoff from exercising now is $38 - $18 = $20, while the net payoff from waiting is either $30 or $32. Since $32 is greater than $20, it is better to wait and not exercise the option now.

Thus, the best choice is (C).

You Own a Share of Common Stock in Vibrapower, Inc