Question 1

Consider a company that is likely to go bankrupt in the next year. Stockholders may wish to pursue negative-NPV projects, even if there is no additional value to the project from real options.

Accepted Answer

Since the company is likely to go bankrupt in the next year, the stockholders may be willing to pursue negative-NPV (Net Present Value) projects in order to maximize their returns before the company goes bankrupt. Real options may not be a factor in the decision-making process in this case.

Question 2

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

Accepted Answer

Hedging involves using financial instruments to reduce financial risks, such as those related to currency fluctuations or commodity prices. Options, forwards, futures, and swaps are all commonly used in hedging strategies.

Question 3

Which of the following statements is true of a put option?

Accepted Answer

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

Question 4

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

Accepted Answer

This option is a European call option, as it can only be exercised on a specific date (third Friday of May, next year) and not before that. It is not an American option because it cannot be exercised at any time before the expiration date. It is a call option because it gives the owner the right to buy the stock at a specified price of $20.

Question 5

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 as hedging tools to manage risks associated with changes in interest rates and foreign exchange rates.

Question 6

Consider a firm with a single loan. There are no interest payments on the loan, but the principal and interest are all due in two years. It is uncertain whether the cash flow the company will produce will be enough to pay off the debt. The payoff to stockholders in this company resembles a call option.

Accepted Answer

The payoff to stockholders in this scenario resembles a call option because they will only receive a positive return on their investment if the company generates enough cash flow to pay off the loan. This creates a scenario where the stockholders have an option to benefit from the company's success, but are not obligated to do so if the company fails to perform.

Question 7

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 firm will avoid financial distress.

Accepted Answer

The answer of Consider a company that is likely to...

Question 8

Which of the following statements is true of a call option?

Accepted Answer

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

Question 9

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

Accepted Answer

A put option gives the buyer the right, but not the obligation, to sell the underlying asset at the strike price to the seller. On the expiration date, the buyer can choose to exercise the option and sell the asset to the seller at the strike price. Therefore, the buyer has the right to sell the asset and the seller has the obligation to buy it.

Question 10

By designing compensation plans with performance bonuses, stock-based compensation, and stock options, corporate boards are attempting to make the payoff function for managers look similar to the payoff function for stockholders.

Accepted Answer

By offering performance bonuses, stock-based compensation, and stock options, corporate boards aim to align the interests of managers and shareholders by making the manager's payoff function more closely resemble that of the stockholder. This encourages managers to make decisions that are beneficial to the company and its shareholders, allowing them to reap the rewards of the company's success.

Question 11

The option payoff function is the relationship:

Accepted Answer

The option payoff function is the relationship between the value of an option and the price of the underlying asset. It shows the profit or loss resulting from buying or selling an option at different prices of the underlying asset. The payoff function of a call option is the maximum of either zero or the difference between the stock price and the strike price. The payoff function of a put option is the maximum of either zero or the difference between the strike price and the stock price.

Question 12

Ecofren Thermostats Co. sells equipment to residential and commercial customers. It is considering whether or not to develop a new line of smart thermostats. The discounted cash flows from smart thermostat sales are not likely to cover the development costs. However, the company has decided to pursue the project anyway. If the commercial technology is successful, it might be applied to a new line of very profitable residential thermostats. This is an example of the option to make follow-on investments.

Accepted Answer

The situation described is an example of the option to make follow-on investments.

Question 13

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 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 farmer has the right to sell her 1,000 bushels of wheat at the strike price of $20 if the spot price falls below that level. This guarantees her a minimum price of $19 per bushel ($20 strike price minus the $1,000 cost of the put option). Therefore, the farmer can ensure that she gets at least $19 a bushel by purchasing the put option.

Question 14

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 proceeds 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. Assume the risk-free interest rate is 0 percent. 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 with a strike price of $14 per bushel, the farmer has promised to sell his soybeans at $14 per bushel if the price of soybeans rises above that level. However, he has bought put options with a strike price of $11.00 per bushel, which give him the right to sell his soybeans at $11.00 per bushel if the price falls. Therefore, he has limited both his potential profits and losses to a range of $14.15 and $11.15 per bushel, respectively. The premiums that he paid and received for the options essentially act as an insurance policy for his soybean crop.

Question 15

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

Accepted Answer

If you exercise the option and buy the stock at $20, then immediately sell it at the current market price of $15, you will incur a loss of $5. Therefore, it is not a good decision to exercise the option in this situation. It would be better to let the option expire worthless and not exercise it.

Question 16

Harmostrax Co. has a defined-benefit pension plan for its employees. To fund the plan, the company makes periodic contributions to a stock investment fund. If the stock 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 stock market.

Accepted Answer

By purchasing put options, Harmostrax Co. would have the right to sell their stock at a predetermined price, protecting them from market downturns. This would hedge their risk and potentially prevent the need for additional contributions to the pension plan.

Question 17

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

Accepted Answer

A call option gives the buyer the right, but not the obligation, to buy the underlying asset at a specified price (strike price) on or before the expiration date. On the expiration date, the buyer can choose to exercise the option and buy the underlying asset, or let the option expire if it is not profitable to exercise. The seller, on the other hand, has the obligation to sell the underlying asset if the buyer decides to exercise the option. Therefore, the correct answer is B: the buyer has the right to buy the underlying asset and the seller has the obligation to sell it.

Question 18

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 corn with a strike price of $15 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 does not guarantee a minimum sale price of $18 per bushel for the farmer; it involves giving someone else the right to buy her corn at the strike price. To guarantee a minimum price, the farmer would need to buy put options, not sell call options.

Question 19

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

Accepted Answer

The put option allows you to sell the stock at the strike price of $35. Since the stock is currently priced at $25, exercising the option lets you sell it for $10 more than the market price, resulting in a $10 profit.

Question 20

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

Accepted Answer

The American call option can be exercised at any time before expiration, which may be advantageous if the stock pays dividends. This flexibility can make it more valuable than a European call option, which can only be exercised at expiration.

Quiz 20: Options and Corporate Finance