  Textbook Solutions Expert Q&A Practice NEW!

Find solutions for your homework

home / study / business / corporate nance / corporate nance solutions manuals / principles of corporate nance: pt. e / 9th edition / chapter 22 / problem 12

Principles of Corporate Finance: Pt. E (9th Edition) Post a question

Answers from our experts for your tough
homework questions
See this solution in the app
Enter question
Chapter 22, Problem 12 Bookmark Show all steps: ON

Problem
Continue to post
16 questions remaining
Buffelhead’s stock price is $220 and could halve or double in each six-month period (equivalent
to a standard deviation of 98%). A one-year call option on Buffelhead has an exercise price of
$165. The interest rate is 21% a year.
Snap a photo from your
a. What is the value of the Buffelhead call? phone to post a question
We'll send you a one-time
download link
b. Now calculate the option delta for the second six months if (i) the stock price rises to $440
and (ii) the stock price falls to $110.
888-888-8888 Text me
By providing your phone number, you agree to rec
a one-time automated text message with a link to
c. How does the call option delta vary with the level of the stock price? Explain intuitively why. the app. Standard messaging rates may apply.

d. Suppose that in month 6 the Buffelhead stock price is $110. How at that point could you
replicate an investment in the stock by a combination of call options and risk-free lending? Show My Textbook Solutions
that your strategy does indeed produce the same returns as those from an investment in the
stock.

Step-by-step solution Principles of College University

Corporate... Physics Physics wit
9th Edition 10th Edition 14th Edition

View all solutions

Step 1 of 4

a. The possible prices of Buffelhead stock and the associated call option values (shown in
parentheses) are:

   

Let p equal the probability of a rise in the stock price. Then, if investors are risk-neutral:

  p (1.00) + (1 – p) × (–0.50) = 0.10

  p = 0.4

If the stock price in month 6 is $110, then the option will not be exercised so that it will be worth:

  [(0.4 × $55) + (0.6 × $0)]/1.10 = $20

Similarly, if the stock price is $440 in month 6, then, if it is exercised, it will be worth ($440 - $165)
= $275. If the option is not exercised, it will be worth:

  [(0.4 × $715) + (0.6 × $55)]/1.10 = $290

Therefore, the call option will not be exercised, so that its value today is:

  [(0.4 × $290) + (0.6 × $20)]/1.10 = $116.36

Stay ahead inComment

class with practice exams
 Step 2 of 4

b. (i) If the price rises to $440:

   

(ii) If the price falls to $110:

   

Comment

Step 3 of 4

c. The option delta is 1.0 when the call is certain to be exercised and is zero when it is certain
not to be exercised. If the call is certain to be exercised, it is equivalent to buying the stock with a
partly deferred payment. So a one-dollar change in the stock price must be matched by a one-
dollar change in the option price. At the other extreme, when the call is certain not to be
exercised, it is valueless, regardless of the change in the stock price.

Comment

Step 4 of 4

d. If the stock price is $110 at 6 months, the option delta is 0.33. Therefore, in order to replicate
the stock, we buy three calls and lend, as follows:

    Initial   Stock   Stock

Price Price
    Outlay    
= 55 = 220

Buy 3
  -60   0   165
calls

Lend
  -50   +55   +55
PV(55)

    -110   +55   +220

This strategy Is equivalent to:    

Buy
  -110   +55   +220
stock

Comment

Was this solution helpful? 0 1

Stay ahead in class with practice exams

 Recommended solutions for you in Chapter 22
Chapter 22, Problem 12

Buffelhead’s stock price is $220 and could halve or

double in each six-month period (equivalent to a
standard deviation of...

See solution

See more problems in subjects you study

Stay ahead in class with practice exams

COMPANY

LEGAL & POLICIES

CHEGG PRODUCTS AND SERVICES

CHEGG NETWORK

CUSTOMER SERVICE

© 2003-2021 Chegg Inc. All rights reserved.

Stay ahead in class with practice exams