Chapter 8 Exam Prep Options

Chapter 8 – Options

MULTIPLE CHOICE

1. The option that gives the owner the right to buy an asset at a fixed price at or before a certain date is called a:

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

2. The price at which the owner of an option can buy or sell the underlying asset is called the:

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

3. An option that gives the owner the right to buy or sell an asset at a fixed price only on the expiration date is called a(n):

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

4. According to the Black and Scholes option pricing model, which of these will lead to an increase in the value of a call option?

REF: 8.4 Option Pricing Models NAT: Reflective thinking

LOC: understand derivative markets

5. When a call option’s strike price is less than the current price of the underlying asset, the call is said to be:

REF: 8.1 Options Vocabulary

NAT: Reflective thinking

LOC: understand derivative markets

6. Smith Enterprises shares currently sell for $18. A call option on the shares has a strike price of $14 and currently sells at $4.50. What is the intrinsic value of the option?

18 – 14 = 4.00

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

7. Smith Enterprises shares currently sell for $18. A put option on the shares has a strike price of $14 and currently sells at $4.50. What is the intrinsic value of the option?

The option is out of the money. Thus, the intrinsic value = 0.

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

8. Smith Enterprises shares currently sell for $17.50. A put option on the shares has a strike price of $15 and currently sells at $4.50. What is the time value of the option?

Intrinsic value = 0

Time value = 4.50

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

9. Smith Enterprises shares currently sell for $18. A call option on the shares has a strike price of $15 and currently sells at $4.50. What is the time value of the option?

Intrinsic value = 18 – 15 = 3

Time value = 4.50 – 3 = 1

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

10. Smith Enterprises shares currently sell for $18. A call option on the shares has a strike price of $21 and currently sells at $4.50. What is the intrinsic value of the option?

The option is out of the money; the intrinsic value = 0.

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

11. Smith Enterprises shares currently sell for $18. A call option on the shares has a strike price of $21 and currently sells at $4. What is the time value of the option?

Intrinsic value = 0

Time value = 4 – 0 = 4.00

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

12. Smith Enterprises shares currently sell for $18. A put option on the shares has a strike price of $21 and currently sells at $4.00. What is the time value of the option?

Intrinsic value = 21 – 18 = 3

Time value = 4.00 – 3.00 = 1

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

13. Smith Enterprises shares currently sell for $18. A put option on the shares has a strike price of $21 and currently sells at $4.00. What is the intrinsic value of the option?

Intrinsic value = 21 – 18 = 3.00

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

14. Suppose you bought 11 Smith Enterprises call options with a strike price of $52 at $3.00 per option. If the price of a Smith share is $50, what is your net profit (or loss)? Ignore the transaction costs.

The option is out of the money.

Loss = 11(3.00) = 33.00

PTS: 1 DIF: M RE

F: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

15. Suppose you bought 10 Smith Enterprises put options with a strike price of $53 at $3.00 per option. If the price of a Smith share is $49, what is your net profit (or loss)? Ignore the transaction costs.

Profit from options = 4(10) = 40

Net profit = 40 – 10(3.00) = 10

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

16. Suppose you bought 10 Smith Enterprises call options with a strike price of $55 at $2.00 per option. If the price of Smith share is $58, what is your net profit (or loss)? Ignore the transaction costs.

Net profit = 10(3) – 10(2.00) = 10

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

17. A call option with a $51 strike price on Bavarian Sausage shares will expire in one year. If you know that the risk-free rate is 4%, a share currently sells at $48 and the put on the same share has a value of $2.75, what is the price of the call?

B = 51/1.04 = 49.04

48 + 2.75 = 49.04 + C

C = 1.71

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

18. A put option with a $51 strike price on Bavarian Sausage shares will expire in one year. If you know that the risk-free rate is 4%, a share currently sells at $48 and the call on the same share has a value of $2.75, what is the price of the put?

B = 51/1.04 = 49.04

48 + P = 49.04 + 2.75

P = 3.79

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

19. A put option with a $50 strike price on Bavarian Sausage shares will expire in one year. If you know a call on the same shares has a value of $2.75, the price of the put is $1.26 and the share is currently selling at $47, what is the implied risk-free rate?

47 + 1.26 = B + 2.75

B = 45.51

50/1 + r = 48.51

r = 0.0987

PTS: 1 DIF: H

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

20. Bavarian Brew issued convertible bonds with a par value of $1000. The conversion ratio on the bonds is 14.45, the current market price of the bonds is $942.75 and the underlying share currently sells at $35.25. What is the conversion price?

942.75/14.45 = 65.24

PTS: 1 DIF: E

REF: 8.5 Options in Corporate Finance NAT: Analytic skills

LOC: understand derivative markets

21. Bavarian Brew issued convertible bonds with a par value of $1000. The conversion ratio on the bonds is 14.45, the current market price of the bonds is $942.75 and the underlying share currently sells at $45.25. What is the conversion premium?

942.75/14.45 = 65.24

(65.24 – 45.25)/45.25 = 0.4418

PTS: 1 DIF: M

REF: 8.5 Options in Corporate Finance NAT: Analytic skills

LOC: understand derivative markets

22. A call option with a $38 strike price on Bavarian Sausage shares will expire in one year. If you know that the risk-free rate is 4%, a share currently sells at $40 and the put on the same share has a value of $3.85, what is the price of the call?

B = 38/1.04 =36.54

40 + 3.85 = 36.54 + C

C = 7.31

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

23. A put option with a $38 strike price on Bavarian Sausage shares will expire in one year. If you know that the risk-free rate is 4%, a share currently sells at $40 and the call on the same share has a value of $6.85, what is the price of the put?

B = 38/1.04 = 36.54

40 + P = 36.54 + 6.85

P = 3.39

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

24. A put option with a $35 strike price on Bavarian Sausage shares will expire in one year. If you know that a share currently sells at $38, that the put on the same share has a value of $6.85 and the value of the call is $11.87, what is the implied risk-free rate?

38 + 6.85 = B + 9.87

B = 32.98

35/(1 + r) = 32.98

r = 0.0612

PTS: 1 DIF: H

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

25. If a company wants to lessen the cost of a new security by imbedding a valuable option in it, then the company is most likely to issue:

REF: Introduction NAT: Reflective thinking

LOC: understand derivative markets

26. One of the main reasons for the name derivatives is that:

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

27. If you purchase the right to sell an IBM share for a set price for a fixed period, then you have:

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

28. An option that gives the holder the right to purchase an underlying security only at the end of a fixed period for a fixed price is a(n):

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

29. Which of the following will increase in price as the value of the underlying asset decreases in price, from the option holder’s perspective?

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

30. You notice that you can purchase an option for $6. The price of the underlying share is currently $42. What is the option premium for this option?

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

31. You currently own a put option on a share with a strike price of $28. If the current price of the share is $32, then what is the in-the-money amount of the option?

REF: 8.1 Options Vocabulary NAT: Analytic skills

LOC: understand derivative markets

32. You own a put option on a share and the strike price of the option is $30. The option has three weeks until expiration, and the share is currently priced at $35 per share. What is the largest payout possible for this put option? Ignore the original cost of the option for the payout calculation.

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

33. You own a call option on a share and the strike price of the option is $30. The option has three weeks until expiration, and the share is currently priced at $35 per share. What is the largest payout possible for this call option? Ignore the original cost of the option for the payout calculation.

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

34. You sold a call option on a share and the strike price of the option is $30. The option has three weeks until expiration, and the share is currently priced at $35 per share. You originally sold the call option for $3. What is the largest payout possible total payout to you for this call option?

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

35. An investor purchases a put option on shares of Company Z. What is the most likely reason that an investor would make such a purchase?

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

36. You purchase a call option and a put option on the shares of a company. The sticker price and expiration date for the options are equal. What is the best description of the combined payoff diagram for the combination of the two options?

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

37. You own 100 shares that have a current price of $50 each, and you also own a put option of 100 shares with a strike price of $42. What is the minimum value of your portfolio at expiration? Ignore the original cost of the put option for your calculation.

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

38. You notice that the price of a one-year call option, with a $40 strike price, is $5. The current price of the underlying share is also $40. What should the price of a one-year put option be with a strike price of $40? Assume that the interest rate on a one-year risk free bond is 10%.

S + P = B/(1 + r) + C

40 + P = 40/1.1 + 5 ===> P = 1.36

PTS: 1 DIF: H

REF: 8.3 Qualitative Analysis of Option Prices NAT: Analytic skills

LOC: understand derivative markets

39. You notice that the price of a one-year put option, with a $60 strike price, is $1. The current price of the underlying share is $58. What should the price of a one-year call option be with a strike price of $60? Assume that the interest rate on a one-year risk free bond is 10%.

S + P = B/(1 + R) + C

58 + 1 = 60/1.1 + C ===> C = 4.45

PTS: 1 DIF: H

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

40. Which of the following will cause a decrease in the value of a related derivative?

REF: 8.3 Qualitative Analysis of Option Prices NAT: Reflective thinking

LOC: understand derivative markets

41. You have written a call option on one share of Z Company that is worth $15. You expect the price of the share to move to either $10 or $20 over the next year. How many shares of Z Company should you own to perfectly hedge your position on the call option? The strike price on the option is $15.

The value of the share will either be $10 or $20.

The value of the option will either be $0 or $5.

20S – 5 = 10S – 0 ===> S = 0.5

PTS: 1 DIF: H

REF: 8.4 Option Pricing Models NAT: Analytic skills

LOC: understand derivative markets

42. You have written a call option on one share of Z Company that is currently worth $15. You expect the price of the share to either move to $10 or $20 over the next year. If the one-year risk-free interest rate is 10% and the strike price on the option is $15, what should have been the proceeds of the option?

Number of shares to hedge: 20S – 5 = 10S – 0 ===> s = 0.5

Payoff in either case: 20(0.5) – 5 = 5; 10(0.5) – 0 = 5 ===> 5/1.1 = 4.55

0.5(15) – C = 4.55 ===> C = 2.95

PTS: 1 DIF: H

REF: 8.4 Option Pricing Models NAT: Analytic skills

LOC: understand derivative markets

43. You need to find the price of a European call option on a share that does not pay dividends. The current price of the share is $50 and the strike price on the option is $50. The expiration date is three months from now and the risk-free rate applicable is 10% per annum. If the standard deviation of the returns on the share is 20%, what is the price of a single call option?

S = 50

X = 50

t = 0.25

r = 0.1

σ = 0.2

Using the Black–Scholes formula: C = SN(d₁) – Xe^–rtN(d₂),
where d₁ = {ln(S/X) + (r + (σ²)/2))t}/(σ × (0.25²)), d₂ = d₁ – (σ × (0.252))

d₁ = 0.3 ===> N(d₁) = 0.617911

d₂ = 0.2 ===> N(d₂) = 0.57926

C = 2.65

PTS: 1 DIF: H

REF: 8.4 Option Pricing Models NAT: Analytic skills

LOC: understand derivative markets

44. According to the Black–Scholes option pricing model, which of the following has the effect of decreasing the value of a call option?

REF: 8.4 Option Pricing Models NAT: Reflective thinking

LOC: understand derivative markets

45. You need to find the price of a European call option on a share that does not pay dividends. The current price of the shares is $100 and the strike price on the option is $80. The expiration date is nine months from now and the risk-free rate applicable is 8% per annum. If the standard deviation on the returns on the share is 50%, what is the price of a single call option?

S = 100

X = 80

t = 0.75

r =0.08

σ = 0.5

Using the Black–Scholes formula C = SN(d₁) – Xe^–rtN(d₂),
where d₁ = {ln(S/X) + (r + (σ²)/2))t}/(σ × (0.75²)), d₂ = d₁ – (σ × (0.75²))

d₁ = 0.87040 ===> N(d₁) = 0.807959

d₂ = 0.43739 ===> N(d₂) = 0.669084

C = 30.39

PTS: 1 DIF: H

REF: 8.4 Option Pricing Models NAT: Analytic skills

LOC: understand derivative markets

46. Which of the following is issued by a company that grants investors the right to buy shares at a fixed price for a given period?

REF: 8.5 Options in Corporate Finance NAT: Reflective thinking

LOC: understand derivative markets

47. An investor that purchases a call option on XYZ shares is hoping that the share price will:

In order for the call option to be in the money, the share price must finish above the strike price at expiration. If the option is not in the money, then it will be worthless at expiration.

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

48. An investor that purchases a put option on ABC shares is hoping that the share price will:

In order for the put option to be in the money, the share price must fall below the strike price at expiration. If the put option is not in the money at expiration, then it will be worthless to the investor.

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

49. An investor who writes a naked call could be considered:

When an investor sells a naked call, she is considered bearish because she is hoping the underlying share does not rise above the strike price. If the share does rise above the strike price, then the investor will have to pay the difference between the strike price and the market price.

PTS: 1 DIF: E

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

50. ABC share is currently trading at $28. A call option on ABC with a strike price of $30 and three months to expiration trades for $2.75. In order for the option to be considered in the money at expiration, an ABC share must be:

In order for a call option to be considered in the money, it only needs to exceed the strike place. It does not matter if the option was actually profitable for the investor.

PTS: 1 DIF: E

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

51. A put on United Pipeline has one year to maturity and a strike price of $45. An investor purchases that option for $3.25. In order for the investor to break even, United Pipeline’s share price on the expiration date must equal:

In order for the investor to breakeven, he must cover the price of the premium he paid for the put option. To do that, the share must decline by the put premium amount below the strike price. Therefore, to breakeven $45 – $3.25 = $41.75.

PTS: 1 DIF: E

REF: 8.3 Qualitative Analysis of Option Prices NAT: Analytic skills

LOC: understand derivative markets

52. An investor purchases two call options on XYZ share with a strike price of $50. The call premium is $2.65 each. The investor will break even at expiration if the share price of XYZ is:

The price of each call option is $2.65. In order to break even, the investor must cover the premium paid for the call option. Therefore, the share price of XYZ must equal $52.65 for the investor to breakeven.

PTS: 1 DIF: M

REF: 8.3 Qualitative Analysis of Option Prices NAT: Analytic skills

LOC: understand derivative markets

53. The main difference between an American and a European option is that:

The main difference between the two types of options is that American options have greater flexibility when it comes to exercising the option. An American option can be exercised at any time until expiration while a European option can only be exercised at expiration.

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

54. Kenly Bennett wants to short shares of Axline Industries. However, his broker cannot find shares available to short. To synthetically produce a short strategy on Axline Industries, Kenly could:

The equation for put–call parity is S + P = B + C. You need to rearrange the equation so that it equals –S. Therefore in order to accomplish this you need to buy a put, borrow the face value of the strike price of the options and short a call. The strike price and expiration date should be equal for both the call and the put option.

PTS: 1 DIF: H

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

55. Shares of Beech Brewery, Inc. trade at $35. Call options with a strike price of $30 trade for $7.50. The options have one year until expiration and the risk-free rate is 4%. According to put–call parity, what should be the price of a $30 put option on Beech Brewery with one year to expiration?

In order to answer this question you need to solve for the P in the equation S + P = B + C. The share price (S) is equal to $35. The present value of a one-year bond (B) with a face value of $30 is $30/1.04 = $28.85, and the price of the call option (C) with a strike price of $30 and one year remaining until expiration is $7.50. So the price of a $30 put option (P) with one year until expiration is equal to $28.85 + $7.50 – $35. This equals $1.35.

PTS: 1 DIF: E

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

56. Jane Lemke purchases a put option on Roofus Corp. for $3.50. The put option has a one-year expiration and a strike price of $35. Currently Roofus Corp. is trading at $38. What is Lemke’s maximum loss on the put option?

The most that an option buyer can lose on a position is the amount she paid for the option. Therefore, Lemke can only lose $3.50 on her Roofus put option.

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

57. Bill Henricksen purchased a put option on Cycle, Inc. for $4. The put option has a strike price of $40 and Cycle, Inc. shares currently trade for $44. The expiration date of the option is six months from today. What is Henricksen’s maximum gain on his put option?

Henricksen’s maximum gain can be computed by subtracting the option premium from the strike price: $40 – $4 = $36. If the share of Cycle, Inc. fell to $0, then the payoff from the put option would be $40. You would then subtract out the $4 he originally paid for the put option to get his maximum gain of $36.

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

58. A call option on Dani Corp. is trading for $4.50. The strike price of the option is $25, and it has an expiration of three months. If the share of Dani Corp. is trading at $28, how much of the option premium is attributed to intrinsic value?

The intrinsic value of an option is the amount by which the option is in the money. In this example, the option strike price is $25 and the share of Dani Corp. is trading at $28. Therefore, the option is $3 in the money, so that is its intrinsic value. The rest of the premium can be attributed to time value.

PTS: 1 DIF: E

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

59. Hannah Monstz is looking to purchase a call option on Thomas Co., which is currently trading at $35. The call option has a strike price of $32.50 and has six months to expiration. If the option has a premium of $5, what is Hannah’s maximum loss on the position?

The most that an investor who buys an option can lose is the premium paid for the option. Therefore, the most that Hannah can lose is $5.

PTS: 1 DIF: E

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

60. Stanley Saeli is an investor who is bullish on LSL Corporation. Currently, LSL Corp. is trading at $51. To profit from his position, Saeli decides to sell put options on LSL Corp. that have a strike price of $45 and one year until expiration. The premium that he would receive on the option is $2.50. What is the most that Saeli can expect to gain per put option?

The most that an investor who sells an option can gain is the premium for which he sold the option. In this case, the most that Saeli can gain is the $2.50 he received when he sold the option, regardless of how LSL Corp. shares move.

PTS: 1 DIF: E

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

61. Nixon Industries call options are currently trading at $35. They all have the same expiration date. Which of these options should trade at the highest price?

If all a company’s options have the same amount of time to expiration, the call option with the lowest strike price will trade at the highest premium, as there is a higher probability that the option will finish in-the-money.

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

62. All of Mac Industries put options have nine months to expiration. Which option should trade at the lowest premium?

If put options related to same underlying share have the same amount of time until expiration, the put option with the lowest strike price should exhibit the lowest premium, as it is the farthest out of the money and the option most likely to finish out of the money at expiration. In this case, the $40 put option would exhibit the lowest premium.

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

63. Jimmy Campbell is looking to buy put options on Hawkwood Corporation. Currently, Hawkwood Corp. is trading at $40 per share. The put options that Campbell is considering buying have a strike price of $45. These put options are:

The problem does not state if the options are American or European, so the only correct answer is in the money.

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary NAT: Reflective thinking

LOC: understand derivative markets

64. Ryan Gates buys a call option on Hoste Enterprise for $3. The call option has a strike price of $35 and six months to expiration. If the price of Hoste Enterprise is $33 in six months, how much is the call option worth at expiration?

At expiration, this call option is out of the money. Therefore, it is worth $0.

PTS: 1 DIF: E

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

65. Lauri Mazurek buys a call option on Piede, Inc. Currently, Piede, Inc. trades at $65 per share. The call option she buys has a strike price of $70 and a premium of $4. What is Mazurek’s breakeven price?

For Mazurek to achieve a profit on this position, she must regain the premium of $4 she paid for the option. To regain this premium, a share of Piede, Inc. would have to rise above $74, making $74 the breakeven price.

PTS: 1 DIF: E

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

66. Kimball Johnson has just purchased a put option on Reut Corporation, which currently trades at $58 per share. The put option has a strike price of $50, six months until expiration and trades at a premium of $3. What is the breakeven price for Johnson’s put option?

The share of Reut Corp. needs to fall to $47 at expiration for Johnson to breakeven on his option position. If the share falls below $47, then Kimball will start to realise a profit from his position.

PTS: 1 DIF: E

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

67. Thomas Duckworth owns and operates Stones Asset Management. The company manages $10 billion in assets and focuses on exploiting arbitrage opportunities. Duckworth uses put–call parity to price put and call options. According to his put–call parity analysis, Duckworth realises that puts with a strike price of $30 and 1one month remaining until expiration on Medusa, Inc. should be priced at $2.30. However, he realises that the $30 puts are trading for $2.75 in the open market. How should Duckworth exploit this arbitrage opportunity?

If Duckworth executes the strategy correctly, he should be able to earn a risk-free profit of $0.45. Based on his analysis, the puts are overpriced in the market. Therefore, he should sell the puts in the open market and synthetically create a long position in the puts. He can accomplish this by lending $30 at the risk-free rate (B), buying a $30 one-month call (C) on the share and shorting Medusa shares (–S). Using the equation S + P = B + C, Duckworth is solving for P. Therefore, P = B + C – S.

PTS: 1 DIF: H

REF: 8.2 Option Payoff Diagrams NAT: Analytic skills

LOC: understand derivative markets

68. An investor who employs a short straddle strategy is hoping that the underlying share price:

An investor that sells a short straddle thinks that the share price is going to be stable. She will realise a profit if the share price does not move much throughout the life of the option.

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

69. Put–call parity says that the price on a portfolio of _________________________ must equal the price of a portfolio of _________________________.

REF: 8.2 Option Payoff Diagrams NAT: Reflective thinking

LOC: understand derivative markets

70. The idea behind the binomial model is that:

REF: 8.4 Option Pricing Models NAT: Reflective thinking

LOC: understand derivative markets

71. Which of the following is not needed to price options using the binomial approach?

REF: 8.4 Option Pricing Models NAT: Reflective thinking

LOC: understand derivative markets

72. Which of the following statements about the binomial model is false?

REF: 8.4 Option Pricing Models NAT: Reflective thinking

LOC: understand derivative markets

73. One key difference between the Black–Scholes option pricing model and the binomial model is that the Black–Scholes model assumes the __________ is known whereas the binomial model does not.

REF: 8.4 Option Pricing Models NAT: Reflective thinking

LOC: understand derivative markets

74. Employee share options are typically __________ when they are issued.

REF: 8.5 Options in Corporate Finance NAT: Reflective thinking

LOC: understand derivative markets

75. Which of the following statements regarding employee share options (ESOs) is false?

REF: 8.5 Options in Corporate Finance NAT: Reflective thinking

LOC: understand derivative markets

76. Based on the following information, what is the value of the put?

PTS: 1 DIF: H

REF: 8.4 Option Pricing Models NAT: Analytic skills

LOC: understand derivative markets

77. Based on the following information, what is the value of the call?

PTS: 1 DIF: H

REF: 8.4 Option Pricing Models NAT: Analytic skills

LOC: understand derivative markets

SHORT ANSWER

1. What is a call option, and what is a put option?

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary

2. List the factors that determine option prices.

PTS: 1 DIF: E

REF: 8.3 Qualitative Analysis of Option Prices

3. Describe the put–call parity relationship.

PTS: 1 DIF: M

REF: 8.2 Option Payoff Diagrams

4. What is a convertible bond?

PTS: 1 DIF: E

REF: 8.5 Options in Corporate Finance

5. What is the difference between American options and European options?

PTS: 1 DIF: E

REF: 8.1 Options Vocabulary

6. Briefly explain the most basic distinction between put and call options.

PTS: 1 DIF: M

REF: Options Vocabulary