Tutorial

Chapter 15: Option Market

1. Explain why an option is a derivative security.
An option’s value depends on or derives from the value of the underlying stock.

2. What is the difference between an option’s price and its payoff?

The option price or premium is what one pays for the option in the market, or what one
receives for selling the option. It is a market-determined price. The payoff of the option is
what it is worth when it expires.

3. If the underlying stock price is $25, indicate whether each of the options below is in
the money, at the money, or out of the money.
Strike price Call option Put option
$20 In the money Out the money
$25 At the money At the money
$30 Out the money In the money

4. At time=0 you buy a call option on IBM for $3.00. The option gives you the right to
buy 100 shares of IBM stock at time=T at $65
i) What is the payoff to you if ST = $70?
ii) What is the payoff for the writer if ST = $70?
iii) What is the payoff to you if ST = $60?
iv) What is the payoff for the writer if ST = $60?
i) St > X ii) St > X
St – X -(St – X)
70 – 65=5 -(70 – 65) = -5

iii) St < X iv) St < X

0 0

5. At time=0 you buy a put option on ITT stock for $2.00. The option gives you the
right to sell 100 shares of ITT stock at time=T at $50
i) What is the payoff to you if ST = $55?
ii) What is the payoff to the put seller if ST = $55?
iii) What is the payoff to you if ST = $45?
iv) What is the payoff to the put seller if ST = $45?
i) St > X ii) St > X
0 0

iii) St < X iv) St < X

X – St -(X – St)
50 – 45 = 5 -(50 – 45) = -5