Deck 8: Financial Options and Applications in Corporate Finance

Question 1

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.

Answer 1

False

Question 2

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.

Answer 2

False

Question 3

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.

Answer 3

False

Question 4

Call options on XYZ Corporation's common stock trade in the market. Which of the following statements is most correct, holding other things constant?

A) The price of these call options is likely to rise if XYZ's stock price rises.
B) The higher the strike price on XYZ's options, the higher the option's price will be.
C) 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.
D) If XYZ's stock price stabilizes (becomes less volatile), then the price of its options will increase.
E) 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.

Question 5

Suppose you believe that Johnson Company's stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $310.25 you can buy a 5-month call option giving you the right to buy 100 shares at a price of $25 per share. If you buy this option for $310.25 and Johnson's stock price actually rises to $45, what would your pre-tax net profit be?

A) -$310.25
B) $1,689.75
C) $1,774.24
D) $1,862.95
E) $1,956.10

Question 6

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.

Question 7

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.

Question 8

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 binominal model, what is the option's value?

A) $2.43
B) $2.70
C) $2.99
D) $3.29
E) $3.62

Question 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.

Question 10

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.

Question 11

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

Question 12

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

Question 13

The exercise value is the positive difference between the current price of the stock and the strike price. The exercise value is zero if the stock's price is below the strike price.

Question 14

Suppose you believe that Delva Corporation's stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put option giving you the right to sell 100 shares at a price of $85 per share. If you bought this option for $510.25 and Delva's stock price actually dropped to
$60, what would your pre-tax net profit be?

A) -$510.25
B) $1,989.75
C) $2,089.24
D) $2,193.70
E) $2,303.38

Question 15

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

A) The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.
B) The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used.
C) An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
D) The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure.

Question 16

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

A) a call option.
B) a put option.
C) an out-of-the-money option.
D) a naked option.
E) a covered option.

Question 17

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) The options with the $25 strike price will sell for $5.
B) The options with the $25 strike price will sell for less than the options with the $35 strike price.
C) The options with the $25 strike price have an exercise value greater than $5.
D) The options with the $35 strike price have an exercise value greater than $0.
E) If Deeble's stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5.

Question 18

Which of the following statements is CORRECT?

A) 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.
B) 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.
C) Issuing options provides companies with a low cost method of raising capital.
D) 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.
E) The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger.

Question 19

Warner Motors' 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) 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.
A) 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.

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

Question 20

Because of the put-call parity relationship, under equilibrium
1.
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.

Question 21

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
Hard:

Question 22

An analyst wants to use the Black-Scholes model to value call options on the stock of Ledbetter Inc. 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