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An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend. The owner of an option is not able to receive any of the proceeds from the underlying stock unless the option is exercised. Once exercised the owner would entitled to the dividends as a stockholder because the stock is owned. The dividends would be received if the option was exercised prior to the ex-dividend date. 2. Which of the following statements is CORRECT? a. If the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as soon as the stocks price exceeds the strike price by about 10%, because this permits the option holder to lock in an immediate profit. This answer was the only one that could not be explicitly eliminated. However, most investors do not actually exercise an option before it expires because the cash flow from selling the option is always equal to or greater than exercising the option. 3. Which of the following statements is CORRECT? d. The market value of an option depends in part on the option's time to maturity and also on the variability of the underlying stock's price. Two of the five factors that affect option prices are time to maturity and volatility of the underlying security. The longer an option has until expiration the

greater its value because over time stocks tend to move up and the longer time gives a better chance for the option to be in-the-money. Therefore, as the time to maturity becomes closer the value for the option will fall all else held constant. The more varied the returns of a security are the higher the risk. The risker the underlying security, the more valuable the option. This is because the losses to the option owner is limit to the cost of the option, and because if the security has more volatility the greater the chance that the stock could go considerably higher than the strike price. 4. The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option's value? c. $2.99 Using the Binomial Option Pricing formula the value of the option is $2.99. The first step after organizing the data in the Excel spreadsheet was to determine the up factor (u) and down factor (d) based on the future price of either $27 or $17. To find divide up or down price by the current price to find the u and d. From that point on the data is arranged and used as the inputs in the Binomial Option Pricing formula. See Excel spreadsheet problem 4. 5. An analyst wants to use the Black-Scholes model to value call options on the stock of Ledbetter Inc. based on the following data c. $3.47

Using the provided data the value of the call option can be found using the black-Scholes equation, which is Vc=P[N(d1)]-Xe-r t[N(d2)]. This provides the

RF

value of the call which is $3.47. See the attached Excel spreadsheet problem 5.

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