Question 1

Jennifer sold a call option on XXX Corp. with an exercise price of $50 and a premium of $3. The option expires today and XXX is currently trading at $40. What is Jennifer's expected profit or loss per share?

Accepted Answer

Profit = $3

Question 2

At what point on the graph of possible values for a call option does the buyer break even financially?

Accepted Answer

The buyer of a call option breaks even when the stock price equals the cost of the option plus the strike price. This is because the buyer recovers the premium paid for the option through the intrinsic value gained from the difference between the stock's market price and the strike price.

Question 3

Which one of the following is correct for the owner of a September put, valued at $20, on CBA Corp. with a strike price of $80? CBA currently trades at $67.

Accepted Answer

As the stock price of CBA decreases, the value of the put option will increase. Therefore, further decreases in the CBA stock price will be translated directly into additional option value. Option A is incorrect because it is not guaranteed that the option will continue to gain value until its September expiration. Option B is also incorrect because exercising the option at the current stock price would result in a loss of the option premium. Option D is incorrect because the option has the potential to increase in value beyond $20 if the stock price of CBA continues to drop.

Question 4

The payoffs from investing in an option contract are designed so that:

Accepted Answer

Option contracts involve a buyer and seller making a bet on the future price of an underlying asset. The payoffs are designed so that if the price moves in the direction that the buyer predicted, the buyer profits and the seller loses, and vice versa. Therefore, the seller's gain is the buyer's loss, and there is no way for both parties to profit. While some buyers may profit more frequently than sellers, it is not accurate to state that a certain percentage of buyers or sellers will always profit.

Question 5

A share of stock is currently priced at $20 and will change with equal likelihood to either $55 or $15. A call option with a $25 exercise price is available on the stock. You want to borrow funds to purchase the stock in order to replicate the call option. How many shares of stock must be purchased to replicate one call option?

Accepted Answer

Shares needed = Max[($55 - 25), $0] - Max[($15 - 25), $0]/($55 - 15) = 0.75

Question 6

A call option will have the highest value when the stock price is:

Accepted Answer

A call option gives the holder the right but not the obligation to buy a stock at a predetermined price (strike price) before a specified expiration date. As the stock price increases, the value of the call option also increases as the holder has the opportunity to buy the stock at a lower price than the current market value. Therefore, the highest value of a call option would be when the stock price is far above the strike price, giving the holder the potential for the greatest profit.

Question 7

Of the following four put options that can be purchased on a stock, which would you expect to have the highest price? (All option months are in the same calendar year.)

Accepted Answer

Options with a later expiration date and a lower exercise price tend to have higher prices. Therefore, the December put with a $75 exercise price would likely have the highest price.

Question 8

Firms spend an increasing amount of time evaluating real options, which are:

Accepted Answer

Real options refer to options on real assets, such as the option to delay, expand, or abandon a project. Firms spend increasing amounts of time evaluating these options to make optimal investment decisions. Options traded on exchanges (B) and call options such as warrants and convertible bonds (C) are financial options, not real options. Put options held by shareholders of firms with financial leverage (D) are also not real options.

Question 9

Which one of the following is correct for the owner of a June call, valued at $3, on XYZ Corp. with a strike price of $60? XYZ Corp. currently trades at $55.

Accepted Answer

If XYZ Corp. continues to trade at $55 per share or lower, the option will expire worthless. Therefore, D is the best choice.

Question 10

It has been determined that 0.5 share of stock should be purchased with borrowed funds to replicate the payoff to one call option. What is the option's strike price if the stock could range in value from $110 to $10 at the expiration of the option?

Accepted Answer

Shares needed = [Max[($110 - x), $0] - $0]/($110 - 10) = 0.5; x = $60

Question 11

It is May 19 and you own a June European call on ABC Corp. with an exercise price of $50. The option trades at $40 and ABC is trading at $86. What should you do?

Accepted Answer

It is not advisable to exercise the option now as it is trading below its intrinsic value (current stock price minus exercise price). Buying more options would increase risk without any clear indication of higher returns. Selling the ABC stock now would not be wise if the price is expected to rise further. Therefore, the best option is to wait until the June expiration to see if the ABC stock price increases further, which may result in a higher option premium or enable to sell the option at a profit.

Question 12

Calculate the return on exercising a put option that was purchased for $10, with an exercise price of $85. The stock price at expiration is $81.

Accepted Answer

Profit % = ($85 - 81 - 10)/$10 = -60%

Question 13

The buyer of a put option has a(n) _____ to sell the underlying asset and the option seller has a(n) ____ to buy the underlying asset.

Accepted Answer

The buyer of a put option has the right, but not the obligation, to sell the underlying asset at a predetermined price before the option expires, while the seller of the put option has the obligation to buy the underlying asset if the option is exercised by the buyer.

Question 14

Under what circumstance will the buyer of a put option be asked to fulfill her obligation?

Accepted Answer

The buyer of a put option has the right, but not the obligation, to sell the underlying asset at the strike price before the option expires. The buyer can choose whether or not to exercise this right, thus they have no obligation to fulfill.

Question 15

When does a change in the value of a call option come the closest to matching the price change in a share of stock?

Accepted Answer

When the stock is priced far above the strike price, the call option behaves more like the stock itself, meaning changes in the stock price will closely reflect in the call option's value. This is because the option is deep in-the-money, making it almost certain to be exercised.

Question 16

Which one of the following statements is correct for an investor who has purchased portfolio insurance by owning a stock and buying a put option on that stock?

Accepted Answer

Portfolio insurance through owning a stock and buying a put option limits the potential downside risk. The put option provides the right to sell the stock at the strike price, so the value per share cannot decline below the strike price less the cost of the option premium. The investor is not necessarily looking to profit from a decline in the stock price, but rather to limit potential losses. Maximum profitability occurs when the stock price exceeds the strike price, as the put option will expire worthless in that scenario. The option may or may not be exercised depending on market conditions and the investor's objectives.

Question 17

At what point is the payoff from owning a call option on a stock greater than the payoff from owning the stock itself?

Accepted Answer

The payoff from owning a call option is the stock price minus the strike price, but only if the stock price exceeds the strike price. However, owning the stock itself provides a payoff equal to the stock price, which will always be greater than or equal to the payoff from the call option.

Question 18

Joe sold a put option on ZZZ Corp. with an exercise price of $40 and a premium of $4. The option expires tomorrow and ZZZ is currently trading at $28 per share. What will be Joe's profit or loss per share if the option is exercised tomorrow and the price remains the same?

Accepted Answer

Profit (loss) = -$40 + 4 + 28 = -$8

Question 19

The value of a call option increases as the time to expiration increases because:

Accepted Answer

As the time to expiration increases, there is more time for the underlying stock price to move in the direction favoring the call option holder, meaning there is a greater opportunity for the stock price to exceed the exercise price and produce a profit for the option holder. This potential for profit makes the option more valuable, thus increasing its price.

Question 20

Stocks that have more volatile price changes have more valuable call options because call holders:

Accepted Answer

Call holders benefit from volatile price changes because they can capture the upside potential of the stock without bearing the downside risk. As a result, options on more volatile stocks have higher prices and are more valuable.

Quiz 23: Options