Chap020.pdf

Chapter 20 - Understanding Options

Chapter 20 Understanding Options Multiple Choice Questions

1. Firms regularly use the following to reduce risk: I) Currency options II) Interest-rate options III) Commodity options A. I only B. II only C. III only D. I, II, and III

2. The following are examples of disguised options for firms: I) acquiring growth opportunities II) ability of the firm to terminate a project when it is no longer profitable III) options that are associated with corporate securities that provide flexibility to change the terms of the issues A. I only B. II only C. I and III only D. I, II, and III

3. An investor, in practice, can buy: I) an option on a single share of stock II) options that are in multiples of 100 III) a minimum order of 100 options on a share of stock A. I only B. II and III only C. II only D. III only

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4. An option that can be exercised any time before expiration date is called: A. an European option B. an American option C. a call option D. a put option

5. The two principal options exchanges in the U.S.A. are: I) International Securities Exchange II) New York Stock Exchange III) NASDAQ IV) Chicago Board of Options Exchange A. II and III only B. I and II only C. I and IV only D. III and IV only

6. The owner of a regular exchange-listed call-option on the stock: A. has the right to buy 100 shares of the underlying stock at the exercise price B. has the right to sell 100 shares of the underlying stock at the exercise price C. has the obligation to buy 100 shares of the underlying stock at the exercise price D. has the obligation to sell 100 shares of the underlying stock at the exercise price

7. The owner of a regular exchange-listed put-option on the stock: A. has the right to buy 100 shares of the underlying stock at the exercise price B. has the right to sell 100 shares of the underlying stock at the exercise price C. has the obligation to buy 100 shares of the underlying stock at the exercise price D. has the obligation to sell 100 shares of the underlying stock at the exercise price

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8. In June 2007, an investor buys a call option on Amgen stock with an exercise of price of $65 and expiring in January 2009. If the stock price in June 2003 is $60, then this option is: I) in-the-money II) out-of-the-money III) a LEAPS A. I only B. II only C. III only D. II and III only

9. The Position diagram for a put with the same exercise price and premium as the call on the same underlying asset with the same maturity is (like): A. the inverse of the call diagram along the put price B. unrelated to the call diagram no matter what the exercise price C. the mirror image of the call diagram around the exercise price D. exactly the same as the call diagram for the given exercise price

10. In June 2007, an investor buys a put option on Genentech stock with an exercise of price of $75 and expiring in January 2009. If the stock price in June 2007 is $80, then this option is: I) in-the-money II) out-of-the-money III) a LEAPS A. I only B. II only C. III only D. I and III only

11. A put option gives the owner the right: A. and the obligation to buy an asset at a given price B. and the obligation to sell an asset at a given price C. but not the obligation to buy an asset at a given price D. but not the obligation to sell an asset at a given price

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12. The buyer of a call option has the right to exercise, but the writer of the call option has: A. The choice to offset with a put option B. The obligation to deliver the shares at exercise price C. The choice to deliver shares or take a cash payoff D. The choice of exercising the call or not

13. Suppose an investor sells (writes) a put option. What will happen if the stock price on the exercise date exceeds the exercise price? A. The seller will need to deliver stock to the owner of the option B. The seller will be obliged to buy stock from the owner of the option C. The owner will not exercise his option D. None of the above

14. The writer (seller) of a regular exchange-listed call-option on the stock: A. has the right to buy 100 shares of the underlying stock at the exercise price B. has the right to sell 100 shares of the underlying stock at the exercise price C. has the obligation to buy 100 shares of the underlying stock at the exercise price D. has the obligation to sell 100 shares of the underlying stock at the exercise price

15. The writer (seller) of a regular exchange-listed put-option on the stock: A. has the right to buy 100 shares of the underlying stock at the exercise price B. has the right to sell 100 shares of the underlying stock at the exercise price C. has the obligation to buy 100 shares of the underlying stock at the exercise price D. has the obligation to sell 100 shares of the underlying stock at the exercise price

16. The value of a put option at expiration is: A. market price of the share minus the exercise price B. higher of the exercise price minus market price of the share and zero C. the exercise price D. none of the above

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17. Figure-1 depicts the:

A. position diagram for the buyer of a call option B. profit diagram for the buyer of a call option C. position diagram for the buyer of a put option D. profit diagram for the buyer of a put option



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A. position diagram for the writer (seller) of a call option B. profit diagram for the writer (seller) of a call option C. position diagram for the writer (seller) of a put option D. profit diagram for the writer (seller) of a put option



21. Suppose an investor buys one share of stock and a put option on the stock. What will be the value of her investment on the final exercise date if the stock price is below the exercise price? (Ignore transaction costs) A. The value of two shares of stock B. The value of one share of stock plus the exercise price C. The exercise price D. The value of one share of stock minus the exercise price

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22. Which of the following investors would be happy to see the stock price rise sharply? I) Investor who owns the stock and a put option II) Investor who has sold a put option and bought a call option III) Investor who owns the stock and has sold a call option IV) Investor who has sold a call option A. I and II only B. III and IV only C. III only D. IV only

23. Buying a call option, investing the present value of the exercise price in T-bills, and short selling the underlying share is the same as: A. Buying a call and a put B. Buying a put and a share C. Buying a put D. Selling a call

24. Buying the stock and the put option on the stock provides the same payoff as: A. investing the present value of the exercise price in T-bills and buying the call option B. on the stock C. short selling the stock and buying a call option on the stock D. writing (selling) a put option and buying a call option on the stock E. none of above

25. Suppose you buy a call and lend the present value of its exercise price. You could match the payoffs of this strategy by: A. Buying the underlying stock and selling a call B. Selling a put and lending the present value of the exercise price C. Buying the underlying stock and buying a put D. Buying the underlying stock and selling a put

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26. Suppose an investor buys one share of stock and a put option on the stock and simultaneously sells a call option on the stock with the same exercise price. What will be the value of his investment on the final exercise date? A. Above the exercise price if the stock price rises and below the exercise price if it falls B. Equal to the exercise price regardless of the stock price C. Equal to zero regardless of the stock price D. Below the exercise price if the stock price rises and above if it falls

27. Put-call parity can be used to show: A. How far in-the-money put options can get B. How far in-the-money call options can get C. The precise relationship between put and call option prices given equal exercise prices and equal expiration dates D. That the value of a call option is always twice that of a put given equal exercise prices and equal expiration dates

28. For European options, the value of a call minus the value of a put is equal to: A. The present value of the exercise price minus the value of a share B. The present value of the exercise price plus the value of a share C. The value of a share plus the present value of the exercise price D. The value of a share minus the present value of the exercise price

29. If the stock makes a dividend payment before the expiration date then the put-call parity is: A. Value of call = value of put + share price - present value (PV) of dividend -PV of exercise price B. Value of call = value of put - share price + PV of dividend - PV of exercise price C. Value of call = value of put + share price + PV of dividend + PV of exercise price D. Value of call = value of put + share price + PV of dividend - PV of exercise price

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30. If the underlying stock pays a dividend before the expiration of the options that will have the following effect on the price of the options: I) increase the value of the call option II) increase the value of the put option III) decrease the value of the call option IV) decrease the value of the put option A. I and II only B. III and IV only C. I and IV only D. II and III only

31. For European options, the value of a call plus the present value of the exercise price is equal to: A. The value of a put minus the value of a share B. The value of a share minus the value of a call C. The value of a put plus the value of a share D. The value of a share minus the value of a put

32. For European options, the value of a put is equal to: A. The value of a call minus the value of a share plus the present value of the exercise price B. The value of a call plus the value of a share plus the present value of the exercise price C. The value of the share minus the value of a call plus the present value of the exercise price D. The value of the share minus the present value of the exercise price plus the valued of a call

33. Given the following data: Expiration = 6 months; Stock price = $80; exercise price = $75; call option price = $12; risk-free rate = 5% per year. Calculate the price of an equivalent put option using put-call parity: A. $3.07 B. $5.19 C. $11.43 D. none of the above

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34. The higher the underlying stock price: (everything else remaining the same) A. higher the put price B. lower the put price C. has no effect on put price D. none of the above

35. The higher the underlying stock price: (everything else remaining the same) A. higher the call price B. lower the call price C. has no effect on call price D. none of the above

36. If the risk-free interest rate increases: A. the direct effect of it on the call option price is positive B. the direct effect of it on the call option price is negative C. the direct effect of it on the call option price is unknown D. none of the above

37. If the volatility of the underlying asset decreases, then the: A. Value of the put option will increase, but the value of the call option will decrease B. Value of the put option will decrease, but the value of the call option will increase C. Value of both the put and call option will increase D. Value of both the put and call option will decrease

38. Which of the following features increase(s) the value of a call option? A. A high interest rate B. A long time to maturity C. A higher volatility of the underlying stock price D. All of the above

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39. A call option has an exercise price of $150. At the final exercise date, the stock price could be either $100 or $200. Which investment would combine to give the same payoff as the stock? A. Lend PV of $100 and buy two calls B. Lend PV of $100 and sell two calls C. Borrow $100 and buy two calls D. Borrow $100 and sell two calls

40. Relative to the underlying stock, a call option always has: A. A higher beta and a higher standard deviation of return B. A lower beta and a higher standard deviation of return C. A higher beta and a lower standard deviation of return D. A lower beta and a lower standard deviation of return

41. If the stock price follows a random walk successive price changes are statistically independent. If σ2 is the variance of daily price change, and there are t days until expiration, the variance of the cumulative price changes is: A. σ2 B. (σ2) * (t) C. (σ2)/t D. none of the above

42. The value of an option (both call and put) is positively related to: I) volatility of the underlying stock price II) time to expiration III) risk-free rate A. I and II only B. II and III only C. I and III only D. III only

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43. The value of a call option is positively related to the following: I) underlying stock price II) risk-free rate III) time to expiration IV) volatility of the underlying stock price A. I only B. II only C. III only D. I, II, III, and IV

44. The value of a call option is negatively related to: I) Exercise price II) Risk-free rate III) Time to expiration A. I only B. II only C. III only D. II and III only

45. The value of a put option is positively related to: I) Exercise price II) Time to expiration III) Volatility of the underlying stock price IV) Risk-free rate A. I, II, and III only B. II, III, and IV only C. I, II, and IV only D. IV only

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46. The value of a put option is negatively related to: I) stock price II) risk-free rate III) exercise price A. I only B. II only C. I and II only D. III only

47. The value of a call option, beyond the stock price less the exercise price, is most likely to be realized when the option is: A. out of the money. B. in the money. C. at the money. D. cannot be determined.

48. If a put and call cost the same, how can an investor offset the cost of a buying a call? A. Borrowing money B. Sell a put C. Sell a stock D. Wait for the stock price to rise

True / False Questions

49. A call options gives its owner the right to buy stock at a fixed strike price during a specified period of time. True False

50. An European option gives its owner the right to exercise the option at any time before expiration. True False

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51. If you write a put option, you acquire the right to buy stock at a fixed strike price. True False

52. The writer of a put option loses if the stock price declines. True False

53. Position diagrams and profit diagrams are one and the same. True False

54. An investor can get downside protection by buying a stock and a put option. True False

55. Buying a stock and a put option, and depositing the present value of the exercise price in a bank account and buying a call provide the same payoff. True False

56. Options can have a value even when the stock is worthless. True False

57. For an European option: Value of call + PV(exercise price) = Value of put + share price. True False

58. An increase in the stock price results in an increase in the call option price. True False

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59. An increase in the exercise price results in an equal increase in the call option price. True False

60. The value of a call option increases with higher volatility of the stock prices. True False

61. It is possible to replicate an investment in a call option by a levered investment in the underlying asset. True False

62. Options written on volatile assets are worth more than options written on safer assets. True False

63. All things being equal, the closer an option gets to expiration, the lower the option price. True False

64. Buying an in the money option will almost always produce a profit. True False

Short Answer Questions

65. Define the term "option."

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66. Explain the difference between a European option and an American option.

67. Define the term "call option."

68. Define the term "put option."

69. Briefly explain how position diagrams are useful?

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70. Explain the main differences between the position diagrams and the profit diagrams.

71. Briefly explain what is meant by "protective put."

72. Briefly explain what is meant by put-call parity?

73. Discuss the factors that determine the value of a call option.

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74. Briefly explain how an option holder gains from the volatility of the underlying stock price.

75. Briefly explain the relationship between risk and option values.

76. Why would an option holder almost never exercise an option early?

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Chapter 20 Understanding Options Answer Key

Multiple Choice Questions

1. Firms regularly use the following to reduce risk: I) Currency options II) Interest-rate options III) Commodity options A. I only B. II only C. III only D. I, II, and III

Type: Medium

2. The following are examples of disguised options for firms: I) acquiring growth opportunities II) ability of the firm to terminate a project when it is no longer profitable III) options that are associated with corporate securities that provide flexibility to change the terms of the issues A. I only B. II only C. I and III only D. I, II, and III

Type: Medium

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3. An investor, in practice, can buy: I) an option on a single share of stock II) options that are in multiples of 100 III) a minimum order of 100 options on a share of stock A. I only B. II and III only C. II only D. III only

Type: Easy

4. An option that can be exercised any time before expiration date is called: A. an European option B. an American option C. a call option D. a put option

Type: Easy

5. The two principal options exchanges in the U.S.A. are: I) International Securities Exchange II) New York Stock Exchange III) NASDAQ IV) Chicago Board of Options Exchange A. II and III only B. I and II only C. I and IV only D. III and IV only

Type: Easy

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6. The owner of a regular exchange-listed call-option on the stock: A. has the right to buy 100 shares of the underlying stock at the exercise price B. has the right to sell 100 shares of the underlying stock at the exercise price C. has the obligation to buy 100 shares of the underlying stock at the exercise price D. has the obligation to sell 100 shares of the underlying stock at the exercise price

Type: Medium

7. The owner of a regular exchange-listed put-option on the stock: A. has the right to buy 100 shares of the underlying stock at the exercise price B. has the right to sell 100 shares of the underlying stock at the exercise price C. has the obligation to buy 100 shares of the underlying stock at the exercise price D. has the obligation to sell 100 shares of the underlying stock at the exercise price

Type: Medium

8. In June 2007, an investor buys a call option on Amgen stock with an exercise of price of $65 and expiring in January 2009. If the stock price in June 2003 is $60, then this option is: I) in-the-money II) out-of-the-money III) a LEAPS A. I only B. II only C. III only D. II and III only

Type: Easy

9. The Position diagram for a put with the same exercise price and premium as the call on the same underlying asset with the same maturity is (like): A. the inverse of the call diagram along the put price B. unrelated to the call diagram no matter what the exercise price C. the mirror image of the call diagram around the exercise price D. exactly the same as the call diagram for the given exercise price

Type: Difficult

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10. In June 2007, an investor buys a put option on Genentech stock with an exercise of price of $75 and expiring in January 2009. If the stock price in June 2007 is $80, then this option is: I) in-the-money II) out-of-the-money III) a LEAPS A. I only B. II only C. III only D. I and III only

Type: Easy

11. A put option gives the owner the right: A. and the obligation to buy an asset at a given price B. and the obligation to sell an asset at a given price C. but not the obligation to buy an asset at a given price D. but not the obligation to sell an asset at a given price

Type: Medium

12. The buyer of a call option has the right to exercise, but the writer of the call option has: A. The choice to offset with a put option B. The obligation to deliver the shares at exercise price C. The choice to deliver shares or take a cash payoff D. The choice of exercising the call or not

Type: Difficult

13. Suppose an investor sells (writes) a put option. What will happen if the stock price on the exercise date exceeds the exercise price? A. The seller will need to deliver stock to the owner of the option B. The seller will be obliged to buy stock from the owner of the option C. The owner will not exercise his option D. None of the above

Type: Medium

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14. The writer (seller) of a regular exchange-listed call-option on the stock: A. has the right to buy 100 shares of the underlying stock at the exercise price B. has the right to sell 100 shares of the underlying stock at the exercise price C. has the obligation to buy 100 shares of the underlying stock at the exercise price D. has the obligation to sell 100 shares of the underlying stock at the exercise price

Type: Medium

15. The writer (seller) of a regular exchange-listed put-option on the stock: A. has the right to buy 100 shares of the underlying stock at the exercise price B. has the right to sell 100 shares of the underlying stock at the exercise price C. has the obligation to buy 100 shares of the underlying stock at the exercise price D. has the obligation to sell 100 shares of the underlying stock at the exercise price

Type: Medium

16. The value of a put option at expiration is: A. market price of the share minus the exercise price B. higher of the exercise price minus market price of the share and zero C. the exercise price D. none of the above

Type: Medium

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Type: Medium



Type: Medium

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Type: Medium



Type: Medium

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21. Suppose an investor buys one share of stock and a put option on the stock. What will be the value of her investment on the final exercise date if the stock price is below the exercise price? (Ignore transaction costs) A. The value of two shares of stock B. The value of one share of stock plus the exercise price C. The exercise price D. The value of one share of stock minus the exercise price

Type: Difficult

22. Which of the following investors would be happy to see the stock price rise sharply? I) Investor who owns the stock and a put option II) Investor who has sold a put option and bought a call option III) Investor who owns the stock and has sold a call option IV) Investor who has sold a call option A. I and II only B. III and IV only C. III only D. IV only

Type: Difficult

23. Buying a call option, investing the present value of the exercise price in T-bills, and short selling the underlying share is the same as: A. Buying a call and a put B. Buying a put and a share C. Buying a put D. Selling a call

Type: Difficult

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24. Buying the stock and the put option on the stock provides the same payoff as: A. investing the present value of the exercise price in T-bills and buying the call option B. on the stock C. short selling the stock and buying a call option on the stock D. writing (selling) a put option and buying a call option on the stock E. none of above

Type: Difficult

25. Suppose you buy a call and lend the present value of its exercise price. You could match the payoffs of this strategy by: A. Buying the underlying stock and selling a call B. Selling a put and lending the present value of the exercise price C. Buying the underlying stock and buying a put D. Buying the underlying stock and selling a put

Type: Difficult

26. Suppose an investor buys one share of stock and a put option on the stock and simultaneously sells a call option on the stock with the same exercise price. What will be the value of his investment on the final exercise date? A. Above the exercise price if the stock price rises and below the exercise price if it falls B. Equal to the exercise price regardless of the stock price C. Equal to zero regardless of the stock price D. Below the exercise price if the stock price rises and above if it falls

Type: Difficult

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27. Put-call parity can be used to show: A. How far in-the-money put options can get B. How far in-the-money call options can get C. The precise relationship between put and call option prices given equal exercise prices and equal expiration dates D. That the value of a call option is always twice that of a put given equal exercise prices and equal expiration dates

Type: Difficult

28. For European options, the value of a call minus the value of a put is equal to: A. The present value of the exercise price minus the value of a share B. The present value of the exercise price plus the value of a share C. The value of a share plus the present value of the exercise price D. The value of a share minus the present value of the exercise price

Type: Difficult

29. If the stock makes a dividend payment before the expiration date then the put-call parity is: A. Value of call = value of put + share price - present value (PV) of dividend -PV of exercise price B. Value of call = value of put - share price + PV of dividend - PV of exercise price C. Value of call = value of put + share price + PV of dividend + PV of exercise price D. Value of call = value of put + share price + PV of dividend - PV of exercise price

Type: Difficult

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30. If the underlying stock pays a dividend before the expiration of the options that will have the following effect on the price of the options: I) increase the value of the call option II) increase the value of the put option III) decrease the value of the call option IV) decrease the value of the put option A. I and II only B. III and IV only C. I and IV only D. II and III only

Type: Difficult

31. For European options, the value of a call plus the present value of the exercise price is equal to: A. The value of a put minus the value of a share B. The value of a share minus the value of a call C. The value of a put plus the value of a share D. The value of a share minus the value of a put

Type: Difficult

32. For European options, the value of a put is equal to: A. The value of a call minus the value of a share plus the present value of the exercise price B. The value of a call plus the value of a share plus the present value of the exercise price C. The value of the share minus the value of a call plus the present value of the exercise price D. The value of the share minus the present value of the exercise price plus the valued of a call

Type: Difficult

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33. Given the following data: Expiration = 6 months; Stock price = $80; exercise price = $75; call option price = $12; risk-free rate = 5% per year. Calculate the price of an equivalent put option using put-call parity: A. $3.07 B. $5.19 C. $11.43 D. none of the above value of put = value of call - share price + PV of exercise price = 12 - 80 + 75/(1.05^0.5) = 12 - 80 + 73.19 = $5.19

Type: Difficult

34. The higher the underlying stock price: (everything else remaining the same) A. higher the put price B. lower the put price C. has no effect on put price D. none of the above

Type: Medium

35. The higher the underlying stock price: (everything else remaining the same) A. higher the call price B. lower the call price C. has no effect on call price D. none of the above

Type: Medium

36. If the risk-free interest rate increases: A. the direct effect of it on the call option price is positive B. the direct effect of it on the call option price is negative C. the direct effect of it on the call option price is unknown D. none of the above

Type: Difficult

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37. If the volatility of the underlying asset decreases, then the: A. Value of the put option will increase, but the value of the call option will decrease B. Value of the put option will decrease, but the value of the call option will increase C. Value of both the put and call option will increase D. Value of both the put and call option will decrease

Type: Difficult

38. Which of the following features increase(s) the value of a call option? A. A high interest rate B. A long time to maturity C. A higher volatility of the underlying stock price D. All of the above

Type: Medium

39. A call option has an exercise price of $150. At the final exercise date, the stock price could be either $100 or $200. Which investment would combine to give the same payoff as the stock? A. Lend PV of $100 and buy two calls B. Lend PV of $100 and sell two calls C. Borrow $100 and buy two calls D. Borrow $100 and sell two calls Value of two calls: 2(200 - 150) = 100 or value of two calls = 2(100 - 150) = 0 (not exercised); payoff = 100 + 100 = 200 or payoff = 0 + 100 = 100

Type: Difficult

40. Relative to the underlying stock, a call option always has: A. A higher beta and a higher standard deviation of return B. A lower beta and a higher standard deviation of return C. A higher beta and a lower standard deviation of return D. A lower beta and a lower standard deviation of return

Type: Difficult

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41. If the stock price follows a random walk successive price changes are statistically independent. If σ2 is the variance of daily price change, and there are t days until expiration, the variance of the cumulative price changes is: A. σ2 B. (σ2) * (t) C. (σ2)/t D. none of the above

Type: Difficult

42. The value of an option (both call and put) is positively related to: I) volatility of the underlying stock price II) time to expiration III) risk-free rate A. I and II only B. II and III only C. I and III only D. III only

Type: Medium

43. The value of a call option is positively related to the following: I) underlying stock price II) risk-free rate III) time to expiration IV) volatility of the underlying stock price A. I only B. II only C. III only D. I, II, III, and IV

Type: Medium

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44. The value of a call option is negatively related to: I) Exercise price II) Risk-free rate III) Time to expiration A. I only B. II only C. III only D. II and III only

Type: Medium

45. The value of a put option is positively related to: I) Exercise price II) Time to expiration III) Volatility of the underlying stock price IV) Risk-free rate A. I, II, and III only B. II, III, and IV only C. I, II, and IV only D. IV only

Type: Medium

46. The value of a put option is negatively related to: I) stock price II) risk-free rate III) exercise price A. I only B. II only C. I and II only D. III only

Type: Medium

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47. The value of a call option, beyond the stock price less the exercise price, is most likely to be realized when the option is: A. out of the money. B. in the money. C. at the money. D. cannot be determined.

Type: Difficult

48. If a put and call cost the same, how can an investor offset the cost of a buying a call? A. Borrowing money B. Sell a put C. Sell a stock D. Wait for the stock price to rise

Type: Difficult

True / False Questions

49. A call options gives its owner the right to buy stock at a fixed strike price during a specified period of time. TRUE

Type: Easy

50. An European option gives its owner the right to exercise the option at any time before expiration. FALSE

Type: Medium

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51. If you write a put option, you acquire the right to buy stock at a fixed strike price. FALSE

Type: Medium

52. The writer of a put option loses if the stock price declines. TRUE

Type: Medium

53. Position diagrams and profit diagrams are one and the same. FALSE

Type: Medium

54. An investor can get downside protection by buying a stock and a put option. TRUE

Type: Difficult

55. Buying a stock and a put option, and depositing the present value of the exercise price in a bank account and buying a call provide the same payoff. TRUE

Type: Difficult

56. Options can have a value even when the stock is worthless. FALSE

Type: Medium

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57. For an European option: Value of call + PV(exercise price) = Value of put + share price. TRUE

Type: Medium

58. An increase in the stock price results in an increase in the call option price. TRUE

Type: Medium

59. An increase in the exercise price results in an equal increase in the call option price. FALSE

Type: Medium

60. The value of a call option increases with higher volatility of the stock prices. TRUE

Type: Medium

61. It is possible to replicate an investment in a call option by a levered investment in the underlying asset. TRUE

Type: Medium

62. Options written on volatile assets are worth more than options written on safer assets. TRUE

Type: Medium

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63. All things being equal, the closer an option gets to expiration, the lower the option price. TRUE

Type: Medium

64. Buying an in the money option will almost always produce a profit. FALSE

Type: Medium

Short Answer Questions

65. Define the term "option." An option is defined as a right, but not an obligation, to buy or sell an underlying asset at a fixed price during a specified period of time.

Type: Easy

66. Explain the difference between a European option and an American option. A European option may be exercised only on the expiration date. An American option may be exercised anytime up to the expiration date.

Type: Easy

67. Define the term "call option." A call option is defined as a right, but not an obligation, to buy an underlying asset at a fixed price during a specified period of time.

Type: Easy

20-37


68. Define the term "put option." A put option is defined as a right, but not an obligation, to sell an underlying asset at a fixed price during a specified period of time.

Type: Easy

69. Briefly explain how position diagrams are useful? Position diagrams show payoffs at option exercise. Share price is plotted on the x-axis and option value on the y-axis. They are useful in analyzing the position of option buyers and sellers at exercise. They do not consider the cost of options.

Type: Medium

70. Explain the main differences between the position diagrams and the profit diagrams. Position diagrams show payoffs at option exercise. Share price is plotted on the x-axis and option value on the y-axis. They are useful in analyzing the position of option buyers and sellers at exercise. They do not consider the cost of options. Profit diagrams on the other hand consider the cost of options also. Profit diagrams provide a clearer picture of profits and losses resulting from trading in options. They are also helpful in analyzing trading strategies.

Type: Difficult

71. Briefly explain what is meant by "protective put." The combination of a stock and a put option is known as a "Protective put." It is like buying insurance against declining stock price. The exercise price of the put option provides a floor to investment in stock. The cost of this insurance is the price of the put option.

Type: Easy

20-38


72. Briefly explain what is meant by put-call parity? The relationship between the value of a European option and the value of an equivalent put option is called put-call parity. It holds only if the investor is committed to holding the options until the exercise date. It does not hold good for American options.

Type: Medium

73. Discuss the factors that determine the value of a call option. The value of a call option is determined by five factors. They are: stock price, exercise price, risk free interest rate, volatility of the stock price, and time to expiration.

Type: Medium

74. Briefly explain how an option holder gains from the volatility of the underlying stock price. An option holder gains from the volatility of the underlying stock price because of the asymmetric payoffs of options. For example, if the stock price falls below the exercise price the call option will be worthless, regardless of whether the drop in the price is only a few cents or many dollars. On the other hand, for every dollar stock price increase above the exercise price will also increase the option price by almost the same amount. Hence, the option holder gains from the increased volatility on the upside, but does not lose on the down side.

Type: Difficult

75. Briefly explain the relationship between risk and option values. Options on volatile (risky) assets are more valuable than options on safer assets. This is in contrast to most financial settings in which risk is a bad thing and investors have to be paid to bear it. The value of an option increases with the volatility of the underlying stock price.

Type: Medium

20-39


76. Why would an option holder almost never exercise an option early? Before expiration, the option value is almost always higher than the value of exercising the option. In the case of a call, the stock price less the exercise price is almost always less than the option price due to volatility and time. As such, the better choice is to sell the option and realize a higher profit.

Type: Difficult

20-40

Chap020.pdf

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