Question 1

A convertible bond can be described as having upside potential with downside protection.

Accepted Answer

A convertible bond offers the upside potential of equity participation through its conversion feature into a predetermined number of shares, while the bond component provides downside protection by ensuring a return of principal at maturity if not converted.

Question 2

You own two put option contracts on Magpie stock with an exercise price of $37.50. What is the total intrinsic value of these contracts if the stock is currently selling for $35.90 a share?

Accepted Answer

The intrinsic value of a put option is calculated as the exercise price minus the current stock price, provided this difference is positive; otherwise, it's zero. For one put option on Magpie stock, the intrinsic value is $37.50 - $35.90 = $1.60. Since each contract typically covers 100 shares, the value per contract is $1.60 * 100 = $160. Owning two contracts doubles this value to $320 in total.

Question 3

Warrants are used to attract lenders.

Accepted Answer

Warrants are used to attract investors, not lenders.

Question 4

A convertible bond should never be worth less than its straight bond value.

Accepted Answer

A convertible bond combines the features of a conventional bond with the option to convert the bond into a specified number of shares of the issuing company, usually at the discretion of the bondholder. Its value is therefore at least equal to its straight bond value (the value it would have without the conversion option) because the conversion option provides additional value. If the stock price increases significantly, the value of the conversion option increases, making the convertible bond worth more. However, if the stock performs poorly, the bond's value will not fall below its straight bond value, as the investor can choose not to convert and instead hold the bond for its fixed income returns.

Question 5

You sold (wrote) five TWX call option contracts with a strike price of $40 when the option was quoted at $3.20. The option expires today when the value of TWX stock is $38.15. Ignoring trading costs and taxes, what is the total profit or loss on your investment?

Accepted Answer

Since the stock price at expiration ($38.15) is below the strike price ($40), the options will expire worthless. This means the writer of the call options keeps the premium received. The total profit is the premium received for the options, which is $3.20 per option x 100 shares per contract x 5 contracts = $1,600.

Question 6

A warrant is a long-term option agreement between two stockholders.

Accepted Answer

A warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed price called the exercise price until the expiry date, and it is issued by the company itself, not an agreement between stockholders.

Question 7

When a warrant is exercised the earnings per share of a corporation decreases.

Accepted Answer

When a warrant is exercised, new shares are issued, increasing the total number of shares outstanding, which can dilute the earnings per share (EPS).

Question 8

A warrant sells for $2 and allows you to buy a share of stock for $5; the current market price of the stock is $6 presents an arbitrage opportunity. (Assume no transaction costs and any option can be exercised immediately).

Accepted Answer

The answer of A warrant sells for $2 and allows...

Question 9

The minimum value of a convertible bond is given by its straight-bond value or its conversion value, whichever is greater.

Accepted Answer

The minimum value of a convertible bond is determined by the higher of its straight-bond value (the value as a regular bond without conversion features) or its conversion value (the value if converted into stock). This ensures that the bondholder receives the maximum possible value.

Question 10

You own a call option on Pester Me stock that expires in one year. The exercise price is $22.50. The current price of the stock is $26.40 and the risk-free rate of return is 4 percent. Assume that the option will finish in the money. What is the value of the call option?

Accepted Answer

The value of a call option is the current stock price minus the present value of the exercise price. Here, the intrinsic value is $26.40 - $22.50 = $3.90. However, since the option will finish in the money, we must also consider the time value. The present value of the exercise price is $22.50 / (1 + 0.04) = $21.63. Thus, the option value is $26.40 - $21.63 = $4.77.

Question 11

The common stock of Winsson, Inc. is currently priced at $52.50 a share. One year from now, the stock price is expected to be either $54 or $60 a share. The risk-free rate of return is 4 percent. What is the value of one call option on Winsson stock with an exercise price of $55?

Accepted Answer

The answer of The common stock of Winsson, Inc. is...

Question 12

You purchased one ABP 35 call option contract at a quoted price of $1.65. What is your net gain or loss on this investment if the price of ABP is $34.20 on the option expiration date?

Accepted Answer

Since the price of ABP ($34.20) is below the strike price of the call option (35), the option expires worthless. Therefore, the loss is equal to the initial cost of the option, which is $1.65 per share for 100 shares, totaling a loss of $165.

Question 13

You own one call option with an exercise price of $30 on Nadia Interiors stock. This stock is currently selling for $27.80 a share but is expected to increase to either $28 or $34 a share over the next year. The risk-free rate of return is 5 percent and the inflation rate is 3 percent. What is the current value of your option if it expires in one year?

Accepted Answer

The answer of You own one call option with an...

Question 14

A convertible bond is similar to a bond with a put option.

Accepted Answer

A convertible bond allows the bondholder to convert the bond into a predetermined number of shares of the issuing company, whereas a bond with a put option allows the bondholder to sell the bond back to the issuer at a specified price before maturity.

Question 15

Last week, you purchased a call option on Denver, Inc. stock at an option price of $1.05. The stock price last week was $28.10. The strike price is $27.50. What is the intrinsic value per share if Denver, Inc. stock is currently priced at $29.03?

Accepted Answer

The answer of Last week, you purchased a call option...

Question 16

Warrants include an implicit call option.

Accepted Answer

Warrants give the holder the right, but not the obligation, to buy a company's stock at a specified price before the warrant expires, similar to a call option.

Question 17

Loan guarantees include an implicit call option.

Accepted Answer

Loan guarantees include an implicit call option because the guarantor has the right, but not the obligation, to fulfill the loan obligations if the borrower defaults, similar to how a call option gives the holder the right to buy an asset at a specified price.

Question 18

New shares of stock are issued when a convertible bond is converted.

Accepted Answer

When a convertible bond is converted, the bondholder exchanges the bond for a predetermined number of new shares of the issuing company's stock, leading to the issuance of new shares.

Question 19

Three weeks ago, you purchased a November 25 put option on Kepner stock at an option price of $1.20. The market price of the stock three weeks ago was $24.30. Today, the stock is selling at $24.80 a share and the November 25 put is priced at $.60. What is the intrinsic value of your put contract?

Accepted Answer

The answer of Three weeks ago, you purchased a November...

Question 20

Warrants can be a source of cash for a firm.

Accepted Answer

Warrants give the holder the right to buy the company's stock at a specific price, and when exercised, the company receives cash as the exercise price is paid directly to it.

Quiz 25: Options and Corporate Securities