Finance Appendix I 1 An option is a contract that gives its holder the right to buy or sell

Ch 08 Financial Options and Applications in Corporate Finance

1. An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified

period of time.

a.

True

b.

False

True

1

False

Options

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2. The strike price is the price that must be paid for a share of common stock when it is bought by exercising a warrant.

a.

True

b.

False

True

1

False

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Ch 08 Financial Options and Applications in Corporate Finance

3. If a stock’s price is above the strike price of a call option written on the stock, then the exercise value is equal to the

stock price minus the strike price. If the stock price is below the strike price, the exercise value of the call option is zero.

a.

True

b.

False

True

1

False

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4. The exercise value is also called the strike price, but this term is generally used when discussing convertibles rather

than financial options.

a.

True

b.

False

1

False

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Ch 08 Financial Options and Applications in Corporate Finance

5. As the price of a stock rises above the strike price, the value investors are willing to pay for a call option increases

because both (1) the immediate capital gain that can be realized by exercising the option and (2) the likely exercise value

of the option when it expires have both increased.

a.

True

b.

False

True

1

False

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6. If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero

value.

a.

True

b.

False

1

False

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7. If the market is in equilibrium, then an option must sell at a price that is exactly equal to the difference between the

stock’s current price and the option’s strike price.

a.

True

b.

False

1

False

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8. Since investors tend to dislike risk and like certainty, the more volatile a stock, the less valuable will be an option to

purchase the stock, other things held constant.

a.

True

b.

False

1

False

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9. Because of the time value of money, the longer before an option expires, the less valuable the option will be, other

things held constant.

a.

True

b.

False

1

False

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10. If we define the “premium” on an option to be the difference between the price at which an option sells and the

exercise value (or the difference between the stock’s current market price and the strike price), then we would expect the

premium to increase as the stock price increases, other things held constant.

a.

True

b.

False

1

False

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11. An option that gives the holder the right to sell a stock at a specified price at some future time is

a.

a put option.

b.

an out–of-the-money option.

c.

a naked option.

d.

a covered option.

e.

a call option.

1

Difficulty: Easy

Multiple Choice

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TYPE: Multiple Choice: Conceptual

8/26/2015 10:45 AM

12. Other things held constant, the value of an option depends on the stock’s price, the risk-free rate, and the

a.

Variability of the stock price.

b.

Option’s time to maturity.

c.

Strike price.

d.

All of the above.

e.

None of the above.

d

1

Difficulty: Easy

Multiple Choice

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13. Which of the following statements is most correct, holding other things constant, for XYZ Corporation’s traded call

options?

a.

The higher the strike price on XYZ’s options, the higher the option’s price will be.

b.

Assuming the same strike price, an XYZ call option that expires in one month will sell at a higher price than

one that expires in three months.

c.

If XYZ’s stock price stabilizes (becomes less volatile), then the price of its options will increase.

d.

If XYZ pays a dividend, then its option holders will not receive a cash payment, but the strike price of the

option will be reduced by the amount of the dividend.

e.

The price of these call options is likely to rise if XYZ’s stock price rises.

1

Difficulty: Easy

Multiple Choice

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Option concepts

TYPE: Multiple Choice: Conceptual

8/26/2015 10:45 AM

14. BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the

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Option value

TYPE: Multiple Choice: Conceptual

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Ch 08 Financial Options and Applications in Corporate Finance

following actions would decrease the value of the options, other things held constant?

a.

The exercise price of the option is increased.

b.

The life of the option is increased, i.e., the time until it expires is lengthened.

c.

The Federal Reserve takes actions that increase the risk-free rate.

d.

BLW’s stock price becomes more risky (higher variance).

e.

BLW’s stock price suddenly increases.

1

Difficulty: Easy

Multiple Choice

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Option concepts

TYPE: Multiple Choice: Conceptual

8/26/2015 10:45 AM

15. Which of the following statements is CORRECT?

a.

Call options give investors the right to sell a stock at a certain strike price before a specified date.

b.

Options typically sell for less than their exercise value.

c.

LEAPS are very short-term options that were created relatively recently and now trade in the market.

d.

An option holder is not entitled to receive dividends unless he or she exercises their option before the stock

goes ex dividend.

e.

Put options give investors the right to buy a stock at a certain strike price before a specified date.

d

1

Difficulty: Easy

Multiple Choice

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Miscellaneous option concepts

16. An investor who writes standard call options against stock held in his or her portfolio is said to be selling what type of

options?

a.

Put

b.

Naked

c.

Covered

d.

Out-of-the-money

e.

In-the-money

c

1

Difficulty: Moderate

Multiple Choice

False

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Options

TYPE: Multiple Choice: Conceptual

8/26/2015 10:45 AM

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17. Cazden Motors’ stock is trading at $30 a share. Call options on the company’s stock are also available, some with a

strike price of $25 and some with a strike price of $35. Both options expire in three months. Which of the following best

describes the value of these options?

a.

The options with the $25 strike price will sell for less than the options with the $35 strike price.

b.

The options with the $25 strike price have an exercise value greater than $5.

c.

The options with the $35 strike price have an exercise value greater than $0.

d.

If Cazden’s stock price rose by $5, the exercise value of the options with the $25 strike price would also

increase by $5.

e.

The options with the $25 strike price will sell for $5.

TYPE: Multiple Choice: Conceptual

8/26/2015 10:45 AM

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Ch 08 Financial Options and Applications in Corporate Finance

Difficulty: Moderate

Multiple Choice

False

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Option value

TYPE: Multiple Choice: Conceptual

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18. Braddock Construction Co.’s stock is trading at $20 a share. Call options that expire in three months with a strike price

of $20 sell for $1.50. Which of the following will occur if the stock price increases 10%, to $22 a share?

a.

The price of the call option will increase by more than $2.

b.

The price of the call option will increase by less than $2, and the percentage increase in price will be less than

10%.

c.

The price of the call option will increase by less than $2, but the percentage increase in price will be more than

10%.

d.

The price of the call option will increase by more than $2, but the percentage increase in price will be less than

10%.

e.

The price of the call option will increase by $2.

c

Difficulty: Moderate

Multiple Choice

False

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Option value

TYPE: Multiple Choice: Conceptual

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19. Which of the following statements is CORRECT?

a.

As the stock’s price rises, the time value portion of an option on a stock increases because the difference

between the price of the stock and the fixed strike price increases.

b.

Issuing options provides companies with a low cost method of raising capital.

c.

The market value of an option depends in part on the option’s time to maturity and also on the variability of the

underlying stock’s price.

d.

The potential loss on an option decreases as the option sells at higher and higher prices because the profit

margin gets bigger.

e.

An option’s value is determined by its exercise value, which is the market price of the stock less its striking

price. Thus, an option can’t sell for more than its exercise value.

c

1

Difficulty: Challenging

Multiple Choice

False

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Options

TYPE: Multiple Choice: Conceptual

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20. Suppose you believe that Basso Inc.’s stock price is going to increase from its current level of $22.50 sometime during

the next 5 months. For $3.10 you can buy a 5-month call option giving you the right to buy 1 share at a price of $25 per

share. If you buy this option for $3.10 and Basso’s stock price actually rises to $45, what would your pre-tax net profit be?

a.

−$3.10

b.

$16.90

c.

$17.75

d.

$22.50

e.

$25.60

b

The call option will be exercised only if the final price is above the strike price. If the final

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21. Suppose you believe that Florio Company’s stock price is going to decline from its current level of $82.50 sometime

during the next 5 months. For $5.10 you could buy a 5-month put option giving you the right to sell 1 share at a price of

$85 per share. If you bought this option for $5.10 and Florio’s stock price actually dropped to $60, what would your pre-

tax net profit be?

a.

−$5.10

b.

$19.90

c.

$20.90

d.

$22.50

e.

$27.60

b

1

False

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22. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly

the same price as a call option on the stock, provided the strike prices for the put and call are the same.

a.

True

b.

False

1

False

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23. If a company announces a change in its dividend policy from a zero target payout ratio to a 100% payout policy, this

action could be expected to increase the value of long-term options (say 5-year options) on the firm’s stock.

a.

True

b.

False

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24. Which of the following statements is CORRECT?

a.

Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the

higher the premium on the option is likely to be.

b.

Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower

the premium on the option is likely to be.

c.

Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the

premium on the option is likely to be.

d.

Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at

exactly the same price as a call option on the stock.

e.

If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call

option prior to its expiration date, even if this would yield an immediate profit.

Difficulty: Moderate

Multiple Choice

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Miscellaneous option concepts

TYPE: Multiple Choice: Conceptual

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Difficulty: Moderate

True / False

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Put-call parity

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25. Which of the following statements is CORRECT?

a.

Call options generally sell at a price less than their exercise value.

b.

If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value.

c.

Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the

exercise value in relation to the strike price, the lower the premium on the option is likely to be.

d.

Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at

exactly the same price as a call option on the stock.

e.

If the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as

soon as the stock’s price exceeds the strike price by about 10%, because this permits the option holder to lock

in an immediate profit.

c

Answer c is correct. See Figure 8−1 and the related discussion.

1

Difficulty: Moderate

Multiple Choice

False

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Miscellaneous option concepts

TYPE: Multiple Choice: Conceptual

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26. The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $55

sells for $7.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option?

a.

$7.33

b.

$7.71

c.

$8.12

d.

$8.55

e.

$9.00

e

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27. The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free

rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available.

Based on the binomial model, what is the option’s value? (Hint: Use daily compounding.)

a.

$2.43

b.

$2.70

c.

$2.99

d.

$3.29

e.

$3.62

c

22 =

$0 =

1

False

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28. An analyst wants to use the Black-Scholes model to value call options on the stock of Heath Corporation based on the

following data:

∙

The price of the stock is $40.

∙

The strike price of the option is $40.

Option range:

shares of stock:

shares of stock =

will be either:

The portfolio’s payoff will be either:

regardless of which choice materializes.

compounded risk-free rate is:

the payoff:

model yields a call value of $2.9950.

Difficulty: Moderate

Multiple Choice

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Option price based on binomial model

TYPE: Multiple Choice: Problem

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Ch 08 Financial Options and Applications in Corporate Finance

∙

The option matures in 3 months (t = 0.25).

∙

The standard deviation of the stock’s returns is 0.40, and the variance is 0.16.

∙

The risk-free rate is 6%.

Given this information, the analyst then calculated the following necessary components of the Black-Scholes model:

∙

d1 = 0.175

∙

d2 = −0.025

∙

N(d1) = 0.56946

∙

N(d2) = 0.49003

N(d1) and N(d2) represent areas under a standard normal distribution function. Using the Black-Scholes model, what is

the value of the call option?

a.

$2.81

b.

$3.12

c.

$3.47

d.

$3.82

e.

$4.20

c

1

Difficulty: Challenging

Multiple Choice

False

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Black-Scholes model

TYPE: Multiple Choice: Problem

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