Chapter 19 OPTIONS Multiple Choice Questions

Overview 1. a. b. c. d. Another name for securities which give the holder the right to buy or sell shares of stock under specified conditions is: CMOs options treasury stock a commitment

(b, easy) Why Have Derivative Securities? 2. a. b. c. d. One important reason for the existence of derivatives is that they: help lower transactions costs. have valuable tax benefits. contribute to market completeness. are risk-free.

(c, moderate) 3. a. b. c. d. Which of the following is not a reason for investors to participate in options? Options eliminate leverage. Options are a smaller investment than stock investments. Options allow investors to trade on the overall market movements. Options can reduce risk.

(a, moderate) Introduction to Options 4. a. b. c. d. The standard option contract is for: 10 shares of stock 50 shares of stock 100 shares of stock 1 share of stock

(c, easy)
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5. a. b. c. d.

An option that allows the investor to buy stock under specified conditions is called a: call put derivative future

(a, easy) 6. a. b. c. d. An option that allows the investor to sell stock under specified conditions is called a: call put derivative future

(b, easy) Understanding Options 7. a. b. c. d. A major difference between new shares being sold by a corporation and shares sold under a call option is that: there is no profit or loss under the shares sold under the call. there is no risk to the investor with the call. there is no increase in the shares outstanding with the call. there is no commission to the investor with the call.

(c, moderate) 8. a. b. c. d. LEAPS are typically: cheaper than short-term options. more expensive than short-term options. less risky than short-term options. more risky than short-term options.

(c, moderate)

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9. a. b. c. d.

The exercise price on an option is also known as the: premium. strike price. theoretical value. spot price.

(b, easy) 10. a. b. c. d. Which of the following statements is true regarding American and European options? American options can be exercised only at expiration. American options can be exercised only in the last week prior to expiration. European options can be exercised only at expiration. European options can be exercised any time prior to expiration.

(c, moderate) 11. a. b. c. d. Which of the following statements is true regarding a call writer: The call writer expects the stock to move upward. The call writer expects the stock to remain the same or move down. The call writer expects the stock to split. The call writer expects to sell the stock prior to expiration of the option.

(b, difficult) 12. a. b. c. d. To hedge a short sale, an investor could buy a call. write a call. buy a put. write a put.

(a, moderate) 13. a. b. c. d. Options sold on exchanges are protected against stock dividends and splits. cash dividends. interest rate movements. inflation.

(a, easy)

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14. a. b. c. d.

Other things equal, after an option first becomes available in the market its time value approaches zero. its time value increases into maturity. the volatility of the stock is negatively related to the value of the call. if it is out of the money, it will have no time value.

(a, moderate) 15. a. b. c. d. A writer of a call can terminate that particular contract anytime before its expiration by writing a second call. buying a put. buying a comparable call. writing a put.

(c, difficulty) Payoffs and Profits from Basic Option Positions 16. a. b. c. d. A call option written against stock owned by the writer is said to be naked. in the money. out of the money. covered.

(d, easy) 17. a. b. c. d. The writer of a naked call faces an unlimited potential gain. a specified potential loss. no chance of loss because this is a conservative strategy. a limited potential gain.

(d, difficult)

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Some Basic Option Strategies 18. a. b. c. d. To provide insurance against declining prices on previously purchased stock, an investor could buy a call. write a put. buy a stock index option. buy a put.

(d, moderate) 19. a. b. c. d. Which of the following statements about portfolio insurance is FALSE? There are several methods of insuring a portfolio. It seeks to provide a minimum return while offering the opportunity to participate in rising prices. Futures are typically not used to hedge stock portfolios. Puts and calls typically are not used to insure portfolios.

(c, moderate) Option Valuation 20. a. b. c. d. The __________ is NOT a determinant of the value of a call option in the Black-Scholes model? interest rate exercise price of the stock price of the underlying stock expected beta of the underlying stock

(d, moderate) 21. a. b. c. d. If the price of the common stock exceeds the exercise price of a call for the holder the call is said to be naked. out of the money. in the money. covered.

(c, moderate)

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22. a. b. c. d.

Option prices usually: increase with maturity. are less than intrinsic values. decrease with a stock's volatility. all of the above.

(a, moderate) 23. a. b. c. d. An option is a wasting asset because as its expiration date approaches, its intrinsic value approaches zero. time value approaches zero. intrinsic value approaches its time value. price approaches zero.

(b, difficult) Questions 24-26 are based on the following options data for XYZ Corporation: ------Call------ ------Put-----Option/Strike Exp. Vol. Last Vol. Last. XYZ 38 5/8 25 Dec. ------- 100 1/8 38 5/8 30 Nov. 250 8 464 1/16 38 5/8 30 Dec. ------- 572 5/16 38 5/8 35 Nov. 154 4 1/2 1748 5/16 38 5/8 35 Dec. 923 5 1/4 580 1 3/16 38 5/8 35 Mar. ------- 33 2 5/8 38 5/8 40 Nov. 2023 1 1/8 530 2 3/8 24. a. b. c. d. Which of the following calls is not "in-the-money?" 25 Dec 30 Nov 35 Dec 40 Nov

(d, moderate) 25. a. b. c. d. Of the various combinations shown above, how many combinations of put contracts are currently trading "out-of-the-money?" 6 5 4 1

(a, moderate)
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26. a. b. c. d.

The closest quote for the Dec. 25 call, were it to trade, would be 12. 4 7/8. 10 1/2. 13 5/8. Solution: Intrinsic value =38 5/8 - 25 =13 5/8

(d, difficult) 27. a. b. c. d. A (an) ---------- seeks to earn a return without assuming risk by constructing riskless hedges. speculator call writer put writer arbitrageur

(d, moderate) 28. a. b. c. d. Which of the following statements is FALSE? An in-the-money call occurs if the stock price exceeds the exercise price. An out-of -the money call occurs if the stock price is less than the exercise price. If a call is out of the money, the intrinsic value is zero. If a call is in the money, the intrinsic value is zero.

(d, moderate) 29. a. b. c. d. Which of the following statements is FALSE? Options are a wasting asset. Option prices almost always exceed intrinsic values. As expiration approaches, the value of the option declines to zero. The intrinsic value of a call is equal to its market value.

(d, moderate) 30. a. b. c. d. Which of the following statements is TRUE? The speculative premium reflects the option's immediate value. If a call is in the money, the intrinsic value is zero. An option's premium almost never declines below its intrinsic value. If exercise price exceeds stock price, a call is "in the money."

(c, moderate)

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31. a. b. c. d.

A stock is at $68. A two-month put (strike price = $70) is available at a $5 premium.. The intrinsic value is ___ and the time value is ____. $5 . . . $0. $0 . . . $5. $3 . . . $2. $2 . . . $3.

(d, difficult) 32. a. b. c. d. In the Black-Scholes model, all of the inputs except two are observable. all of the inputs except one are observable. the greater the stock price, the lower the price of the call option. there is an inverse relationship between the value of a call and interest rates in the market.

(b, difficult, p. 526) An Investor's Perspective on Puts and Calls 33. a. b. c. d. Concerning index options, which of the following statements is FALSE? Index options appeal to speculators due to the leverage they offer. Investors can write index options. If exercised the holder of an index option receives the strike price. Index options are settled in cash.

(c, difficult) 34. a. b. c. d. The best way to protect a stock portfolio in a bear market is to: Buy stock index calls. Buy stock index puts. Write stock index calls. Write stock index puts.

(b, difficult) 35. a. b. c. d. Stock market index options are available on all of the following EXCEPT the Standard and Poor's 500 Index. the Major Market Index. the National OTC Index. the Shearson Lehman Hutton Index.

(d, moderate)

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APPENDIX 19-A
36. a. b. c. d. A combination of one put and one call on the same stock with the same exercise price and date is known as a: strip straddle strap spread

(b, easy) 37. a. b. c. d. The two basic spreads are the: time spread and price spread put spread and call spread time spread and money spread money spread and rate spread

(c, moderate) 38. a. b. c. d. A combination of two calls and one put is called a: strip strap straddle spread

(b, moderate) 39. a. b. c. d. Spreads are used to: increase the return potential circumvent option commissions reduce risk in an option position. all of the above are true.

(c, moderate)

True/False Questions
Understanding Options 1. An option buyer has only two courses of action available: exercise the option or let it expire.

(F, moderate)
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2.

The options clearing corporation ensures fulfillment of option obligations.

(T, easy) 3. The writer of a put, like the buyer of a call, is bullish about the stock price.

(T, easy) 4. Options traded on organized exchanges are protected against cash dividends.

(F, moderate) 5. Options cannot be purchased on margin.

(F, moderate) Some Basic Option Strategies 6. A protective put is a strategy in which a short seller buys a put.

(F, moderate) Payoffs and Profits from Basic Option Strategies 7. A covered call is considered a type of spread.

(F, moderate) Option Valuation 8. If the price of the underlying common stock is less than the exercise price of a put, it is in the money.

(T, easy) 9. There is an inverse relationship between the price of a call option and the volatility of the underlying common stock.

(F, difficult) 10. Writing a naked put is riskier than writing a naked call.

(F, difficult)

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An Investor's Perspective on Puts and Calls 11. The strategies with stock index options are considerably different from those for individual stocks.

(F, easy)

Short-Answer Questions
Understanding Options 1. (easy) Answer: All contracts are actually bought and sold through the Options Clearing Corporation, which stands behind the contracts. What organizational feature of options trading prevents individual traders from having to worry about defaults if options are exercised?

Some Basic Option Strategies 2. What is meant by portfolio insurance?

(moderate) Answer: Portfolio insurance involves strategies to provide the portfolio a minimum return while allowing it to participate in rising prices. Securities usually include options, futures and synthetic options. Futures on indexes are commonly used to offset stock portfolio losses.

3.

A stock investor wants to hedge the Dell stock in his portfolio. How can he use a covered call to do this?

(difficult) Answer: The investor owns the stock and will profit if it increases in value or lose if it decreases. He can write a call and receive the premium from it. The premium will partially offset the loss if the stock price declines. If the stock price increases, he may be called upon to sell it at the exercise price. This would limit his potential gains.

4.

A stock investor wants to hedge the Microsoft stock in his portfolio. How can he use a protective put to do this?

(difficult)

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Answer:

The investor owns the stock and will profit if it goes up and lose if it goes down. He buys a put. If the stock increases in value, he gains on the stock and loses the premium he paid for the put. If the stock goes down, he can exercise the put and sell the stock at the exercise price.

Payoffs and Profits from Basic Option Strategies 5. How can the owner of a large stock portfolio use options on individual stocks to enhance the income from the portfolio?

(moderate) Answer: The owner of a portfolio may enhance the portfolios income by writing calls and puts for the premium received. If the purchaser exercises the option, however, the writer will have to deliver the stock and may have to take capital losses. Option Valuation 6. What is a hedge ratio?

(difficult) Answer: The hedge ratio for a call is N(d1) from the Black-Scholes model. It is commonly called delta. It shows the change in the price of the option for a $1 change in the price of the underlying stock. The hedge ratio for a put is N(d1) 1. This knowledge helps the portfolio manager determine how many options contracts are needed to protect the portfolio from price fluctuations.

7.

What is the put-call parity? How is it related to arbitrage?

(difficult) Answer: This principle expresses the relationship between the prices of puts and calls on the same stock that must hold if arbitrage is to be ruled out. In other words, unless the price of the put and call have a certain relationship to each other, there will be opportunities for earnings riskless profits (arbitrage).

Critical Thinking/Essay Questions

1. What makes the risk-expected return profile attractive to speculators who purchase put and call options? What is the risk-expected return profile for writers of naked put and call options?

(difficult)

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Answer:

Put and call options offer leverage compared to purchasing the common stock. The upside for puts and calls is unlimited because the potential increase (decrease) in the stock price is unlimited. The downside on options is limited to a 100 percent loss because no margin is allowed. The loss on highly levered futures contracts can be far more. Thus, the advantage of options to speculators is the unlimited upside and the limited downside. In addition, speculators can enter this market with very small amounts of cash compared to the investment required for the stocks themselves. The writer of naked options faces unlimited loss because the stock price can move up without limit or down to zero. The upside gain is limited to the amount received for the option.

2.

What are the variables in the Black-Scholes option pricing model? How is each related to the price of the call option?

(moderate) Answer: Price of underlying stock. The higher the stock price, the higher the option price. Exercise price. The higher the exercise price, the lower the option price. Time remaining to expiration. The longer the time, the higher the option price. Interest rate. The higher the interest rate, higher the option price. Volatility of underlying stock. The higher the volatility, the higher the option price.

Problems
1. AB Flex Inc. stock is currently trading at $38. The time left until expiration of a call and put trading on AB Flex Inc.'s stock is 6 months and the strike price is $45. If the call is currently trading at $1.96 and the Treasury bill rate is 10 percent per year, what price should the put sell for?

(difficult) Solution: Use put-call parity. Price of put = = = = EP/(ert) CMP + CP 45/(e0.1*0.5) 38 + 1.96 45/1.051271 38 + 1.96 6.77

2.

SCORP has puts and calls available for trading for the expiration months of June, September, and December. For the trading day May 2, 199X, SCORP closed at $40 per share. Strike prices for SCORP are $35, $40, and $45. The following prices for the 9 call options (3 expiration dates and 3 strike prices) for this date were (in scrambled order):
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A. B. C. D. E.

5 4 2 1/16 6 3/8 3 1/8

F. G. H. I.

4 7/8 3/4 7 1/4 2 7/16

Fill in the following matrix of prices for these calls, using LETTERS ONLY (i.e., A through I) (difficult) $35 $40 $45 June ________ ________ ________ September ________ ________ ________ September D B C December ________ ________ ________ December H F I

Solution: June $35 A $40 E $45 G 3.

An investor has the alternative of buying 100 shares of XYZ at $50 per share or investing the same amount of money in XYZ 6-month calls priced at $5. Calculate the profit or loss from each strategy if the price of XYZ rises to $60 within a week.

(moderate) Solution: Buying the stock gain = $10 per share x 100 shares = $1000

Buying 10 option contracts ($5000 to invest/$500 per option contract): gain 4. = 10 options contracts x assumed $10 gain on options = 10 x 1000 per contract = $10,000 ABC, which closed at $151, has call options trading in April, July, and October with the following values: April 11 1 July 11 3 1 ------------Calls------------October 13 4 2

Options/Strike ABC 140 151 150 151 160 (a) (b)

Calculate the intrinsic value of the April 150 call. Calculate the intrinsic value of the April 140 call.

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(c)

Should the price of ABC rise to $156, what is the minimum value that the April 150 call should trade at?

(moderate) (a) (b) (c) 5. Intrinsic value = Intrinsic value = Minimum value= 151 - 150 151 - 140 156 - 150 = = = $1.00 $11 $6

Listed below are the option quotes on JUP, Inc., in January of this year. March 3 1/2 2 1 1/2 r June 4 1/2 4 1/2 8 3/8 r s

-------Calls--------------Puts-------Options/Strike March June JUP 35 37 40 1 1/2 37 45 1 37 50 1/2 (a) (b) (c) (d) (e)

1 1/8 5 s

Which calls are in the money? Which puts are in the money? Why are investors willing to pay 3 1/2 for the MARCH 35 call but only 1/2 for the March 35 put? Calculate the intrinsic value of the June 35 call. Calculate the intrinsic value of the March 40 put.

(difficult) Solution: (a) In-the-money calls are those whose EP<SP. Since the SP = 37 only the March 35 calls is in the money. (b) (c) In-the-money puts are those whose EP>SP. Hence the March 40, March 45 and June 40 puts are in-the-money. The investors are willing to pay 3 1/2 for the March 35 call option because it has an intrinsic value of 2 and the rest is speculative premium. Investors are probably expecting the stock to go up by March. On the other hand, the March 35 put is out-of-the money i.e. it's intrinsic value is zero. There is still some chance that the price may drop below 35, at which time the investor may make a profit. Hence there is a small speculative premium of 1/2 on the put option. Intrinsic Value of June 35 Call Price 37 - 35 = $2 The Intrinsic Value of the March 40 put Price
254

(d) = (e)

Stock Price - Exercise

Exercise Price - Stock

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= 6.

40 - 37 = $3 Use the Black-Scholes model to calculate the theoretical value of a DBA December 45 call option. Assume that the risk free rate of return is 6 percent, the stock has a variance of 36 percent, there are 91 days until expiration of the contract, and DBA stock is currently selling at $50 in the market.

(difficult) Solution: Where EP r t N(d1) CMP = = = = Value of Call = CMP[N(d1)] [EP/ert][N(d2)] $100 91/365 = (r + 0.52)t = 0.36 0.25

= Current market price = Strike price = $90 risk-free rate = 0.06 time till maturity in years = cumulative density function of d1 d1 = ln(CMP/EP) + t1/2

2 = N(d2) = d1 = = d2 = = =

variance of the stock's annual rate of return cumulative density function of d2 d2 = d1 - t1/2 ln(100/90) +

[0.06 + 0.5(.36)](0.25) (0.36)1/2 (0.25)1/2

[0.10536 + 0.06]/0.3 0.5512 = 0.5512 - 0.6(0.5) 0.5512 - .3 0.2512 0.7088 (from standard normal table) 0.5987 (from standard normal table)

N(d1) = N(d2) =

Value of the call = [$100(.7088)] - [$90/e(0.06)(0.25)][.5987] = 70.88 - [90(.9851)(.5987)] = $70.88 - $53.08 = $17.80 7. You buy 1,000 shares of Sunbeam at 11 1/8 and write 10 calls at a premium of 4 3/8 with a strike price of 7 1/2. The stock goes to 20 in 6 months. You receive a 8 cent dividend per share. If the calls are exercised (which is the likely assumption), what is your percentage return?

(moderate)

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Loss on selling stock = sell stock at 7.5 x 1,000 = $7,500 bought stock at 11.125 x 1,000 = 11,125 (3,625) Dividends received = .08 x 1,000 = $80 Premium received on writing calls = 4.375 x 100 x 10 = $4,375 Total return = $830 Percentage return = $830/11,125 = 7.5%

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