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Chapter 05: Financial Options
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
ANSWER:
True
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
ANSWER:
True
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
ANSWER:
True
Chapter 05: Financial Options
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
ANSWER:
False
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
ANSWER:
True
Chapter 05: Financial Options
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
ANSWER:
False
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
ANSWER:
False
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
ANSWER:
False
Chapter 05: Financial Options
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
ANSWER:
False
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
ANSWER:
False
Chapter 05: Financial Options
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.
ANSWER:
a
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.
ANSWER:
d
Chapter 05: Financial Options
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.
ANSWER:
e
14. BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the
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.
ANSWER:
a
Chapter 05: Financial Options
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.
ANSWER:
d
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
ANSWER:
c
Chapter 05: Financial Options
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.
ANSWER:
d
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.
ANSWER:
c
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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.
ANSWER:
c
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
Chapter 05: Financial Options
d.
$22.50
e.
$25.60
ANSWER:
b
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
ANSWER:
b
Chapter 05: Financial Options
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
ANSWER:
False
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
ANSWER:
False
Chapter 05: Financial Options
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.
ANSWER:
e
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.
ANSWER:
c
Chapter 05: Financial Options
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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
ANSWER:
e
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.
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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
Chapter 05: Financial Options
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.
∙
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
ANSWER:
c
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