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**Chapter 21 Option Valuation
**

Multiple Choice Questions 1. Before expiration, the time value of an in the money call option is always A. equal to zero. B. positive. C. negative. D. equal to the stock price minus the exercise price. E. none of the above.

The difference between the actual option price and the intrinsic value is called the time value of the option.

Difficulty: Easy

2. Before expiration, the time value of an in the money put option is always A. equal to zero. B. negative. C. positive. D. equal to the stock price minus the exercise price. E. none of the above.

The difference between the actual option price and the intrinsic value is called the time value of the option.

Difficulty: Easy

21-1

3. Before expiration, the time value of an at the money call option is always A. positive. B. equal to zero. C. negative. D. equal to the stock price minus the exercise price. E. none of the above.

The difference between the actual option price and the intrinsic value is called the time value of the option.

Difficulty: Easy

4. Before expiration, the time value of an at the money put option is always A. equal to zero. B. equal to the stock price minus the exercise price. C. negative. D. positive. E. none of the above.

Difficulty: Easy

5. At expiration, the time value of an in the money call option is always A. equal to zero. B. positive. C. negative. D. equal to the stock price minus the exercise price. E. none of the above.

Difficulty: Easy

Chapter 21 - Option Valuation

6. At expiration, the time value of an in the money put option is always A. equal to zero. B. negative. C. positive. D. equal to the stock price minus the exercise price. E. none of the above.

Difficulty: Easy

7. At expiration, the time value of an at the money call option is always A. positive. B. equal to zero. C. negative. D. equal to the stock price minus the exercise price. E. none of the above.

Difficulty: Easy

8. At expiration, the time value of an at the money put option is always A. equal to zero. B. equal to the stock price minus the exercise price. C. negative. D. positive. E. none of the above.

Difficulty: Easy

21-3

9. A call option has an intrinsic value of zero if the option is A. at the money. B. out of the money. C. in the money. D. A and C. E. A and B.

Intrinsic value can never be negative; thus it is set equal to zero for out of the money and at the money options.

Difficulty: Easy

10. A put option has an intrinsic value of zero if the option is A. at the money. B. out of the money. C. in the money. D. A and C. E. A and B.

Intrinsic value can never be negative; thus it is set equal to zero for out of the money and at the money options.

Difficulty: Easy

11. Prior to expiration A. the intrinsic value of a call option is greater than its actual value. B. the intrinsic value of a call option is always positive. C. the actual value of call option is greater than the intrinsic value. D. the intrinsic value of a call option is always greater than its time value. E. none of the above.

Prior to expiration, any option will be selling for a positive price, thus the actual value is greater than the intrinsic value.

Difficulty: Moderate

Chapter 21 - Option Valuation

12. Prior to expiration A. the intrinsic value of a put option is greater than its actual value. B. the intrinsic value of a put option is always positive. C. the actual value of put option is greater than the intrinsic value. D. the intrinsic value of a put option is always greater than its time value. E. none of the above.

Prior to expiration, any option will be selling for a positive price, thus the actual value is greater than the intrinsic value.

Difficulty: Moderate

13. If the stock price increases, the price of a put option on that stock __________ and that of a call option __________. A. decreases, increases B. decreases, decreases C. increases, decreases D. increases, increases E. does not change, does not change

As stock prices increases, call options become more valuable (the owner can buy the stock at a bargain price). As stock prices increase, put options become less valuable (the owner can sell the stock at a price less than market price).

Difficulty: Moderate

21-5

decreases. B. increases. E. the time to expiration. decreases D. the exercise price. Difficulty: Moderate . D. call options become less valuable (the owner can buy the stock at a bargain price). the price of a stock call option is positively correlated with the following factors except A. none of the above. decreases C.14. Difficulty: Moderate 15. decreases. the stock volatility. does not change As stock prices decreases. the stock price. increases. C. If the stock price decreases. increases E. put options become more valuable (the owner can sell the stock at a price less than market price). does not change. the price of a put option on that stock __________ and that of a call option __________. As stock prices decreases. The exercise price is negatively correlated with the call option price. Other things equal. A. increases B.

B. Other things equal. the exercise price.Chapter 21 . and C. The exercise price is negatively correlated with the call option price.Option Valuation 16. A. the stock volatility. D. C. the price of a stock call option is positively correlated with the following factors A. the stock price. B. Difficulty: Moderate 21-7 . the time to expiration. E.

the time to expiration. the stock volatility. the stock volatility. Other things equal. none of the above. B. the time to expiration. the stock volatility. D. the exercise price. B. the price of a stock put option is positively correlated with the following factors except A. the stock price. D. Other things equal. C. The exercise price is negatively correlated with the call option price. E. The exercise price is negatively correlated with the stock price. B. B. D. the price of a stock call option is negatively correlated with the following factors A. the exercise price. Difficulty: Moderate . A. and D. and C. the time to expiration. E. C. the stock price. Difficulty: Moderate 18. B. Difficulty: Moderate 19. the exercise price. Other things equal. C. the stock price. The exercise price is negatively correlated with the stock price. the price of a stock put option is positively correlated with the following factors A. C. E.17.

Other things equal. D. The higher the striking price. and D. not. positively B. E. positively C. A. B. negatively D. The price of a stock put option is __________ correlated with the stock price and __________ correlated with the striking price. the price of a stock put option is negatively correlated with the following factors A. negatively E. C. the time to expiration.Option Valuation 20. the exercise price. B. the more valuable the call option. C. The exercise price is negatively correlated with the stock price. Difficulty: Moderate 21-9 . the stock price. negatively. positively. the more valuable the put option. the stock volatility. negatively. not The lower the stock price. positively. Difficulty: Moderate 21.Chapter 21 .

The price of a stock call option is __________ correlated with the stock price and __________ correlated with the striking price. The higher the striking price. positively B. negatively. not. negatively E. positively. negatively D. the more valuable the put option.22. Difficulty: Moderate . negatively. positively. positively C. A. the more valuable the call option. not The lower the stock price.

Difficulty: Moderate 24. the risk free rate of interest. from scenario analysis. E. Difficulty: Moderate 21-11 . Which of the inputs in the Black-Scholes Option Pricing Model are directly observable A. C. B. the time to expiration. D. B. but must be estimated from historical data. A. none of the above. All the inputs in the Black-Scholes Option Pricing Model are directly observable except A. or from the prices of other options. The variance of the returns of the underlying asset is not directly observable. but must be estimated from historical data. E. C. the variance of returns of the underlying asset return. the variance of returns of the underlying asset return. and C. the risk free rate of interest.Option Valuation 23. D. the price of the underlying security. The variance of the returns of the underlying asset is not directly observable. B. from scenario analysis. or from the prices of other options. the price of the underlying security.Chapter 21 . the time to expiration.

Delta is defined as A. the change in the volatility of the underlying stock price. the percentage change in the value of an option for a one percent change in the value of the underlying asset. C.25. the change in the value of the underlying asset for a dollar change in the call price. Difficulty: Moderate . D. An option's hedge ratio (delta) is the change in the price of an option for $1 increase in the stock price. none of the above. the change in the value of an option for a dollar change in the price of the underlying asset. B. E.

70 means that as the stock increases in value by $1. none of the above.70 calls for each short stock. A slope of 0.85. long 0. 0. B. long 0.85 means that as the stock increases in value by $1. The hedge ratio is the slope of the option value as a function of the stock value.85 shares for each short call.70 shares of stock would be needed to hedge the investor's portfolio. long 0. A hedge ratio of 0.70 implies that a hedged portfolio should consist of A. C.85 calls for each long stock.85 calls for each short stock. E. the option increases by approximately $0. long 0.Option Valuation 26. D. short 0. Difficulty: Moderate 21-13 .70 shares for each long call. D. C. The hedge ratio is the slope of the option value as a function of the stock value. Difficulty: Moderate 27. long 0.85 implies that a hedged portfolio should consist of A.Chapter 21 .85 shares for each long call. for every call written.70 shares for each short call. Thus.70. short 0. A hedge ratio of 0. Thus. none of the above.70 calls for each long stock.85 shares of stock would be needed to hedge the investor's portfolio. A slope of 0. long 0. the option increases by approximately $0. 0. E. B. for every call written.

negative D. equal to one. between minus one and zero. and put option ratios must be negative. Difficulty: Moderate . B. of no restricted value Call option hedge ratios must be positive and less than 1. E.0. Difficulty: Moderate 29. greater than one. between minus one and zero. between zero and one D. positive. C. with a smaller absolute value than 1. with a smaller absolute value than 1. negative. A hedge ratio for a put is always A. between zero and one D.0. positive B. of no restricted value Call option hedge ratios must be positive and less than 1. A hedge ratio for a call is always A. E. positive.0. negative C. B. equal to one. negative.0. Difficulty: Moderate 30. and put option ratios must be negative. A hedge ratio for a call option is ________ and a hedge ratio for a put option is ______.0. with a smaller absolute value than 1. A. positive E. zero. and put option ratios must be negative. zero Call option hedge ratios must be positive and less than 1.0. C.28. greater than one.

the gamma of the option. A and C. C. C. E. Difficulty: Moderate 32. B and C.Option Valuation 31. The dollar change in the value of a stock call option is always A. B. B. none of the above. lower than the dollar change in the value of the stock. the elasticity of the option. the delta of the option. The percentage change in the stock call option price divided by the percentage change in the stock price is called A.Chapter 21 . negatively correlated with the change in the value of the stock. Option price elasticity measures the percent change in the option price as a function of the percent change in the stock price. The slope of the call option valuation function is less than one. the theta of the option. D. Difficulty: Moderate 21-15 . D. E. higher than the dollar change in the value of the stock.

the continued updating of the hedge ratio as time passes. B. the volatility level for the stock that the option price implies. The elasticity of an option is A. Difficulty: Moderate . A and C. C. the sensitivity of the delta to the stock price. Option price elasticity measures the percent change in the option price as a function of the percent change in the stock price. D. E.33. the percentage change in the stock call option price divided by the percentage change in the stock price.

smaller than one. The gamma of an option is A. A and C. Difficulty: Moderate 21-17 . Option prices are much more volatile than stock prices. infinite E. as option premiums are much lower than stock prices. the percentage change in the stock call option price divided by the percentage change in the stock price. Difficulty: Moderate 36. the continued updating of the hedge ratio as time passes.Chapter 21 . C. the sensitivity of the delta to the stock price. B. smaller than one. D. the volatility level for the stock that the option price implies. Difficulty: Moderate 35. D. B. As put options become more valuable as stock prices decline. negative D. none of the above. none of the above.Option Valuation 34. greater than one. E. The elasticity of a stock call option is always A. positive. negative. the elasticity of a put option must be negative. C. infinite. B. The gamma of an option is the sensitivity of the delta to the stock price. C. The elasticity of a stock put option is always A. E.

E. Dynamic hedging is A. is the continued updating of the hedge ratio as time passes. the sensitivity of the delta to the stock price. C. the volatility level for the stock that the option price implies. Difficulty: Moderate . B. C. means the portfolio has no tendency to change value as the underlying portfolio value changes.37. D. the continued updating of the hedge ratio as time passes. Dynamic hedging is the continued updating of the hedge ratio as time passes. D. Delta neutral A. E. A and C. the percentage change in the stock call option price divided by the percentage change in the stock price. B. is the volatility level for the stock that the option price implies. is the percentage change in the stock call option price divided by the percentage change in the stock price. Difficulty: Moderate 38. Delta neutral means the portfolio has no tendency to change value as the underlying portfolio value changes. A and C.

E. B. A and C.Chapter 21 . Difficulty: Moderate 21-19 . the sensitivity of the delta to the stock price.Option Valuation 39. D. C. Volatility risk is A. Volatility risk is the risk incurred from unpredictable changes in volatility. the volatility level for the stock that the option price implies. the risk incurred from unpredictable changes in volatility. the percentage change in the stock call option price divided by the percentage change in the stock price.

800 shares = 800 shares.7. The call delta is 0. E. The two portfolios have the same exposure D. E. Which portfolio has a higher dollar exposure to a change in stock price? A. 575 shares = 575 shares. Which portfolio has a higher dollar exposure to a change in stock price? A. Portfolio B consists of 800 shares of stock. 300 calls (0. 500 calls (0.6. Portfolio A consists of 500 shares of stock and 500 calls on that stock. The call delta is 0. Portfolio B B. Difficulty: Difficult .7) = 210 shares + 150 shares = 360 shares. A if the stock price increases and B if it decreases. The two portfolios have the same exposure D. Portfolio A C.40. Portfolio B consists of 575 shares of stock. Portfolio A consists of 150 shares of stock and 300 calls on that stock. Portfolio A C. B if the stock price decreases and A if it increases. Portfolio B B. B if the stock price decreases and A if it increases. A if the stock price increases and B if it decreases. Difficulty: Difficult 41.6) = 300 shares + 500 shares = 800 shares.

Portfolio B consists of 500 shares of stock. The two portfolios have the same exposure D. Which portfolio has a higher dollar exposure to a change in stock price? A. Portfolio B B.5) = 200 shares + 400 shares = 600 shares. A if the stock price increases and B if it decreases.Chapter 21 . Portfolio A consists of 400 shares of stock and 400 calls on that stock.Option Valuation 42. B if the stock price decreases and A if it increases.5. E. Difficulty: Difficult 21-21 . 400 calls (0. Portfolio A C. The call delta is 0. 500 shares = 500 shares.

685 shares = 685 shares. Portfolio B consists of 685 shares of stock.7)] = -$1. B if the stock price decreases and A if it increases. The two portfolios have the same exposure D.3) = 90 shares + 600 shares = 690 shares. 300 calls (0.43. The call delta is 0. Which portfolio has a higher dollar exposure to a change in stock price? A.7.150 D. A portfolio consists of 100 shares of stock and 1500 calls on that stock. A if the stock price increases and B if it decreases. If the hedge ratio for the call is 0. +$700 B.500(0. none of the above -$100 + [-$1. -$1.150. Difficulty: Difficult 44. what would be the dollar change in the value of the portfolio in response to a one dollar decline in the stock price? A. Portfolio A consists of 600 shares of stock and 300 calls on that stock. -$520 E. +$500 C. E. Portfolio A C. Difficulty: Difficult . Portfolio B B.3.

If the hedge ratio for the call is 0. A portfolio consists of 800 shares of stock and 100 calls on that stock. -$580 D. Difficulty: Difficult 21-23 .5)] = -$850. none of the above -$800 + [-$100(0. +$700 B. What would be the dollar change in the value of the portfolio in response to a one dollar decline in the stock price? A.Option Valuation 45. -$850 C.Chapter 21 .5. -$520 E.

none of the above -$400 + [-$200(0.46. +$500 C. If the hedge ratio for the call is 0. -$580 D. what would be the dollar change in the value of the portfolio in response to a one dollar decline in the stock price? A. A portfolio consists of 400 shares of stock and 200 calls on that stock. Difficulty: Difficult . Difficulty: Difficult 47.6. If the hedge ratio for the call is 0. A portfolio consists of 225 shares of stock and 300 calls on that stock. +$700 B.4. -$520 E. +$500 C. -$520 E. none of the above -$225 + [-$300(0. what would be the dollar change in the value of the portfolio in response to a one dollar decline in the stock price? A.6)] = -$520. -$345 B. -$580 D.4)] = -$345.

1.0 = -0.30. -0.70 B.3 .17 Call hedge ratio = N(d1). 0. A.Chapter 21 . If the hedge ratio for a stock call is 0. Difficulty: Difficult 21-25 . the hedge ratio for a put with the same expiration date and exercise price as the call would be ________.30 E.70 D. 0.1. -0. 0. Put hedge ratio = N(d1) .30 C.Option Valuation 48. -.7.

0. A. If the hedge ratio for a stock call is 0. Put hedge ratio = N(d1) .70 D. If the hedge ratio for a stock call is 0.0 = -0.17 Call hedge ratio = N(d1).1.30 C. Put hedge ratio = N(d1) . -.7 .6 .1.17 Call hedge ratio = N(d1). 0.70 B. -0.30 B. -0.50 C.17 Call hedge ratio = N(d1).40 E. 0. the hedge ratio for a put with the same expiration date and exercise price as the call would be ________. A.60 B.50 E.1. 0.50.49. Difficulty: Difficult 50.70. -0. 0.5. -.40 C.0 = -0.60.30 E. -0. 0. the hedge ratio for a put with the same expiration date and exercise price as the call would be _______. If the hedge ratio for a stock call is 0.60 D. Difficulty: Difficult 51. Put hedge ratio = N(d1) .60 D. the hedge ratio for a put with the same expiration date and exercise price as the call would be _______.1. 0. -0. A. Difficulty: Difficult .4. 0.3.5 . -0.1.1.0 = -0. -. 0.

0.70 .05.05/0. If the hedge ratio for the put is -0. C.0.76 E. -2. D. a portfolio of 50 bonds.30 and the stock is currently selling for $46.2. -7.Chapter 21 . a portfolio that corresponds to the S&P 500.021739 = .30 C. % option price change = $5. E.30.00)/ $6 = . 2. a portfolio that replicates the Dow. Difficulty: Easy 21-27 .30 % stock price change = ($47 .76 B. what is the elasticity of the put? A. -2. a portfolio of 100 shares of IBM stock. 2.$6.$46)/$46 = 0. The S&P 500 index is more like a portfolio that corresponds to the S&P 500 and thus is more protective of such a portfolio than of any of the other assets.Option Valuation 52. a portfolio of 50 shares of AT&T and 50 shares of Xerox stocks. A. B. A put option on the S&P 500 index will best protect ________. .021739. A put option is currently selling for $6 with an exercise price of $50.67 D. Difficulty: Difficult 53.

positive. and thus lower the current call option value and increase the current put option value. Higher dividend payout policies have a __________ impact on the value of the call and a __________ impact on the value of the put. Difficulty: Moderate . A. negative D. zero. zero Dividends lower the expected stock price. positive C. negative. negative. positive.54. negative B. positive E.

Difficulty: Moderate 21-29 . A. A. negative. less than E. increase. decrease. increase.Option Valuation 55. less than D. positive. zero Dividends lower the expected stock price. Lower dividend payout policies have a __________ impact on the value of the call and a __________ impact on the value of the put. zero.Chapter 21 . Difficulty: Moderate 56. more than C. thus changes in stock prices (market or exercise) are greater (in absolute terms) than are changes in prices of options. A one dollar decrease in a call option's exercise price would result in a(n) __________ in the call option's value of __________ one dollar. and thus lower the current call option value and increase the current put option value. positive E. exactly Option prices are less than stock prices. negative B. positive C. negative D. increase. decrease. negative. more than B. positive.

I. and IV only. III) Dividend yield of underlying stock. I. II) Time to expiration of the option. III. C. E. II and III only. I. B. III. I. I and IV only.57. D. I. B. II and III only. II. II and III only. IV) Stock price volatility. E. IV) Stock price volatility. I. II. Difficulty: Moderate . Difficulty: Moderate 58. and IV only. All of the above variables affect put option prices. A. A. I and IV only. II) Time to expiration of the option. and IV. Which one of the following variables influence the value of put options? I) Level of interest rates. C. and IV. II. III) Dividend yield of underlying stock. II. All of the above variables affect call option prices. II and III only. D. Which one of the following variables influence the value of call options? I) Level of interest rates.

only exercise the call when the stock price exceeds the previous high C. D. are more valuable. will always be exercised earlier. Rather. E. C. Relative to European puts. thus American puts should sell for more than European puts.Chapter 21 . none of the above. Difficulty: Moderate 21-31 . B. D. the option buyer will sell the option to collect both the intrinsic value and the time value. It is valuable to exercise a put option early if the stock drops below a threshold price. B. buy an offsetting put whenever the stock price drops below the strike price. none of the above.Option Valuation 59. never exercise the call early. always exercise the call as soon as it is in the money. E. exercising forfeits the time value. Difficulty: Moderate 60. otherwise identical American put options A. An American call option buyer will not exercise early if the stock does not pay dividends. An American call option buyer on a non-dividend paying stock will A. are less valuable. are equal in value.

+4/7 C. the two possibilities for ST are $150 and $80. +4/7 D. Use the two-state put option value in this problem. $0 and $40.61. +1/2 When ST = $150. ($0 . The range of P across the two states is _____. -4/7 E. $20 and $40. X = $120. -4/7 B. A. Difficulty: Difficult . P = $0. $0 and $40.$80) = -4/7. $0 and $50. the hedge ratio is _______. when ST =$80: P = $40. SO = $100.$40)/($150 . $0 and $50.

show that the model generates values fairly close to the prices at which options trade.4919 = $5. A.(0. N(d2) = 0. No dividends will be paid before option expires.16.00. C. r = 0. indicate that the mispricing that does occur is due to the possible early exercise of American options on dividend-paying stocks.16. T = 70 days. A. and C. Difficulty: Difficult 63. A and C. $0.16. E. Given: SO = $70. none of the above.Chapter 21 .020506 (daily).$70[e-(0.06 annually (0. D.01853781. The other statements are true.5600.0001648)(70)]0. B. X = $70. C = 0. $5. Difficulty: Difficult 21-33 . d2 = 0. $10. show that the model tends to overvalue deep in the money calls and undervalue deep out of the money calls.5600($70) . The value of the call option is _______. C. Empirical tests of the Black-Scholes option pricing model A. Use the Black-Scholes Option Pricing Model for the following problem. D. s = 0.1530277 . B. E.16. B. N(d1) = 0. $2.020506)(70)1/2 = -0.4919. Studies have shown that the model tends to undervalue deep in the money calls and to overvalue deep out of the money calls.0001648 daily).Option Valuation 62.

$0 D. Options sellers who are delta-hedging would most likely A. The call premium is $12. $12 B. The underlying stock now sells for $43. buy whether markets are falling or rising. sell whether markets are falling or rising.35 = $8. Options sellers who are delta-hedging would most likely sell when markets are falling and buy when markets are rising. Difficulty: Easy .64. 65. What is the intrinsic value of the call? A. Difficulty: Moderate An American-style call option with six months to maturity has a strike price of $35. E. $8 C. D. $23 E. both A and B. 43 . sell when markets are falling B. none of the above. buy when markets are rising C.

$8 B.Chapter 21 . $12 C.Option Valuation 66.35) = $4. What is the time value of the call? A. $0 D. Difficulty: Moderate 21-35 . 12 .(43 . $4 E. cannot be determined without more information.

5 [(12. $3. $5.00 P = 12 .00 B.79.02 C. $2.43 + 35/(1.12)/12] / [(44 .5. 2.32 C. 0. 4. 1.5 E.43)/43] = 1. what is its elasticity? A.79 D.5.25 E.00 Difficulty: Difficult . If the risk-free rate is 6%. $12.06).67.00 D.50 . Difficulty: Difficult 68.17 B. If the option has delta of . 1. $8. what should be the value of a put option on the same stock with the same strike price and expiration date? A. P = $3.

If the company unexpectedly announces it will pay its first-ever dividend 3 months from today. the call price would not change. the call price would decrease. the put price would decrease. you would expect that A. the put price would not change. the call price would increase. B. D. C. the option value will be lower. subtract the present value of the dividend from the stock price and recompute the Black-Scholes value with this adjusted stock price.Chapter 21 . Difficulty: Moderate 21-37 . As an approximation. E. Since the stock price is lower.Option Valuation 69.

volatile markets may cause trading halts. option elasticity. gamma hedging.70. E. dynamic hedging. price quotes may be delayed so that correct hedge ratios cannot be computed. B. rebalancing. Since deltas change as stock values change. C. D. C. Difficulty: Moderate 71. portfolio insurance. dynamic hedging may be difficult to implement because A. All of the above correctly describe the problems associated with dynamic hedging in volatile markets. Dynamic hedgers will convert equity into cash in market declines to adjust for changes in option deltas. B. portfolio hedge ratios must be constantly updated in active markets. historical deltas are too low. as volatility increases. all of the above. In volatile markets. Difficulty: Easy . This process is referred to as A. E. prices move too quickly for effective rebalancing. D.

Rubinstein believes this is due to fear of another market crash. none of the above.Chapter 21 . higher than normal dividend payouts. investor fears of another market crash.Option Valuation 72. C. Rubinstein (1994) observed that the performance of the Black-Scholes model had deteriorated in recent years. decreases in transaction costs. early exercise of American call options. but the exhibit progressively different implied volatilities. and he attributed this to A. D. E. Options on the same stock with the same strike price should have the same implied volatility. B. Difficulty: Moderate 21-39 .

73. The time value of a put option is I) the difference between the option's price and the value it would have if it were expiring immediately. II E. III) the difference between the option's price and its expected future value. A. and is different from the time value of money concept frequently used in finance. Difficulty: Easy . I B. II) the same as the present value of the option's expected future cash flows. Difficulty: Easy 74. II and III D. II E. I and II C. II) the same as the present value of the option's expected future cash flows. The time value of a call option is I) the difference between the option's price and the value it would have if it were expiring immediately. IV) different from the usual time value of money concept. II and III D. IV) different from the usual time value of money concept. I and II C. A. I B. I and IV The time value of an option is described by I. and is different from the time value of money concept frequently used in finance. I and IV The time value of an option is described by I. III) the difference between the option's price and its expected future value.

D. two times the value of the stock. Do not exercise the call to avoid a negative net return on the investment. C. one. You purchased a call option for a premium of $4. The current stock price is $31. Difficulty: Moderate 76. As the underlying stock's price increased. Exercise the call to get a positive net return on the investment. your return will be ($31 . infinity As the stock price increases the value of the call option increases in price one for one with the stock price. If you exercise the call. Do not exercise the call because the difference between the exercise price and the stock price is not enough to cover the amount of the premium. E. The option is very likely to be exercised. B. Do not exercise the call because the stock price is greater than the exercise price.Option Valuation 75.Chapter 21 . B. Exercise the call because the stock price is greater than the exercise price. The call has an exercise price of $29 and is expiring today. But if you don't exercise the call your return will be -$4/4 = -100%. one-half time s the value of the stock. Difficulty: Moderate 21-41 . E. the call option valuation function's slope approaches A. What would be your best course of action? A.4)/$4 = -50%.29 . zero. D. C.

C.77. I. E. II and IV E. I and III C. The model also assumes that stock prices will not jump markedly. IV) there will be no sudden extreme jumps in stock prices. It never pays to exercise this call option before maturity. I and II B. Difficulty: Moderate 78. none of the above. are less valuable. The holder of the call who wants to close out the position would be better off selling the call because the value of the call must exceed the potential proceeds from its exercise. A. B. Therefore the right to exercise the American call early has no value and it should be equal in value to the European call. Difficulty: Difficult . will always be exercised earlier. III. II) the stock price volatility is constant over the life of the option. D. are equal in value. are more valuable. and IV The risk-free rate and stock price volatility are assumed to be constant but the option value does not depend on the expected rate of return on the stock. The Black-Scholes formula assumes that I) the risk-free interest rate is constant over the life of the option. Relative to non-dividend-paying European calls. II and II D. otherwise identical American call options A. I. III) the expected rate of return on the stock is constant over the life of the option. II.

less E. Difficulty: Easy 81. less B.Chapter 21 . NORMALDIST The textbook gives an example of how to use Excel to calculate some of the variables in the model. The hedge ratio of an option is also called the options _______. greater C. Which Excel formula is used to execute the Black-Scholes option pricing model? A.Option Valuation 79. delta E. beta C. ABNORMAL C. greater. alpha B. NORMSDIST D.8. sigma D. A. greater D. so movements in their prices cause greater percentage changes Difficulty: Moderate 21-43 . DIST E. less. NORMAL B. Dollar movements in option prices are ________ than dollar movements in the stock price. greater. There is no particular pattern. A. See Figure 21. less. rho The two terms mean the same thing. and rate of return volatility of options is ________ than stock return volatility. Options cost less than the stock. Difficulty: Easy 80.

$6 D. $8 B. $12 B. The call premium is $14. What is the intrinsic value of the call? A. What is the time value of the call? A.42) = $6. 50 . Difficulty: Easy 83. 14 . cannot be determined without more information. $4 E. $10 C. Difficulty: Moderate . $23 E. none of the above. $8 D. $12 C.42 = $8.An American-style call option with six months to maturity has a strike price of $42. The underlying stock now sells for $50.(50 . 82.

the more valuable the option. Discuss the relationship between option prices and time to expiration. as the owner of the option may be required to sell the stock at a lower than market price. the put price would decrease. The longer the time to expiration. move from an out of the money to an in the money option. as the option owner can buy the stock at a lower price. the higher the premium because it is more likely that an option will become more valuable (more time for the stock price to change). subtract the present value of the dividend from the stock price and recompute the Black-Scholes value with this adjusted stock price. E.Chapter 21 . and the differences and similarities of these variables on put and call option prices. the put price would not change. Since the stock price is lower. the greater the option premium. Difficulty: Moderate 21-45 . the more likely it is that the option will become more valuable (e. and the exercise price. the more volatile the stock. D. For a put option. the lower the exercise price. The greater the volatility of the underlying stock. C. If the company unexpectedly announces it will pay its first-ever dividend 4 months from today. g. Feedback: The purpose of this question is to insure that the student understands the relationships of the variables that determine option prices. Difficulty: Moderate Short Answer Questions 85.. the lower the exercise price. the call price would not change. the option value will be lower. you would expect that A. the call price would decrease. volatility of the underlying stocks. B. or become more in the money). the less valuable the option. the call price would increase. For call options. As an approximation.Option Valuation 84.

A call option has a positive hedge ratio. Investors often use the implied volatility of the stock. the higher the price of the option. Feedback: The purpose of this question is determine whether the student understands hedge ratios and how these ratios vary for puts and calls. Difficulty: Moderate . the volatility of the stock implied by the price of the option. Difficulty: Difficult 87. the "fair price" of the option would exceed the actual price. An option's hedge ratio is the change in the price of an option for a $1 increase in the stock price. If actual volatility appears to be higher than the implied volatility. the option would be considered to be underpriced. Which of the variables affecting option pricing is not directly observable? If this variable is estimated to be higher or lower than the variable actually is how is the option valuation affected? The volatility of the underlying stock is not directly observable. Feedback: The purpose of this question is to determine whether the student understands how some investors use option pricing based on implied volatility to determine if the option appears to be over or undervalued. The hedge ratio is the slope of the value function of the option evaluated at the current stock price. a put option has a negative hedge ratio. but can be estimated from historic data. as the higher the implied volatility. i.. If investors think the actual volatility of the stock exceeds the implied volatility. the option will be undervalued. If the implied volatility is lower than the actual volatility of the stock.e. What is an option hedge ratio? How does the hedge ratio for a call differ from that of a put (or are the two equivalent)? Explain.86.

Assume that you will hold one share.Option Valuation 88. What is the hedge ratio? How much would you borrow to purchase the stock? What is the amount of your net investment in the stock? Complete the table below to show the value of your stock portfolio at the end of the holding period. 21-47 . There is a call option available on the stock with an exercise price of $35. How many call options will you combine with the stock to construct the perfect hedge? Will you buy the calls or sell the calls? Show the option values in the table below. Show the net payoff to your portfolio in the table below. Over the investment period you think that the stock price might get as low as $25 or as high as $40.Chapter 21 . Answer the following questions about hedging your position in the stock. You are evaluating a stock that is currently selling for $30 per share.

What must the price of one call option be? .

Chapter 21 . Complete the table below to show the value of your stock portfolio at the end of the holding period. if it ends at $25 the call is worth $0. Show the net payoff to your portfolio in the table below.58 = $6.06 = $23.0)/(40 .25) = 1/3.] How much would you borrow to purchase the stock? Borrow the present value of the anticipated minimum stock price = $25/1.Option Valuation The answers are shown below. What is the hedge ratio? The hedge ratio equals the range of the call values divided by the range of the stock values.23.58 What is the amount of your net investment in the stock? The net amount of investment is $30 . 21-49 . which equals (5 . Show the option values in the table below. [If the stock price ends at $40 the call is worth $5. How many call options will you combine with the stock to construct the perfect hedge? Will you buy the calls or sell the calls? Since the hedge ratio is 1/3 buy one stock and sell three call options.42.

and C = $2. The net investment in the stock portfolio is $6. $30 .58.42 = 3C.14. Alternatively.3C = $23. and C = $2.What must the price of one call option be? The value of the stock portfolio equals the value of three calls. Feedback: This question tests the student's ability to construct a perfect hedge on a stock portfolio using call options. $6.14.58.42 so this must equal the value of the three calls.3C = $23. the value of the whole position must equal the present value of the certain payoff: S . Difficulty: Difficult .

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