Course name: Foundations of Financial Management (10248) – Fall I, 2013

Assignment name: Week 7 Questions/Problems

1. Use the Black-Scholes model to find the price for a call option with the following inputs: (1) current stock price is $32, (2) strike price is $35, (3) time to expiration is 6 months, (4) annualized risk-free rate is 3%, and (5) variance of stock return is 0.26. Round your answer to the nearest cent.

$

2. A call option on the stock of Bedrock Boulders has a market price of $7. The stock sells for $29 a share, and the option has an exercise price of $24 a share.What is the exercise value of the call option?

$

What is the option’s time value?

$

3. The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $55 sells for $7.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option?

a. $7.71

b. $8.55

c. $7.33

d. $9.00

e. $8.12

4. Which of the following statements is CORRECT?

a. As the stock’s price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases.

b. Issuing options provides companies with a low cost method of raising capital.

c. The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger.

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.

e. An option’s value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option can’t sell for more than its exercise value.

5. Call options on XYZ Corporation’s common stock trade in the market. Which of the following statements is most correct, holding other things constant?

a. If XYZ pays a dividend, then its option holders will not receive a cash payment, but the strike price of the option will be reduced by the amount of the dividend.

b. The higher the strike price on XYZ’s options, the higher the option’s price will be.

c. Assuming the same strike price, an XYZ call option that expires in one month will sell at a higher price than one that expires in three months.

d. The price of these call options is likely to rise if XYZ’s stock price rises.

e. If XYZ’s stock price stabilizes (becomes less volatile), then the price of its options will increase.

Deeble Construction Co.’s stock is trading at $30 a share. Call options on the company’s stock are also available, some with a strike price of $25 and some with a strike price of $35. Both options expire in three months. Which of the following best describes the value of these options?

a. The options with the $25 strike price will sell for less than the options with the $35 strike price.

b. If Deeble’s stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5.

c. The options with the $35 strike price have an exercise value greater than $0.

d. The options with the $25 strike price have an exercise value greater than $5.

e. The options with the $25 strike price will sell for $5.

The exercise price on one of Flanagan Company’s options is $15, its exercise value is $21, and its time value is $4. What are the option’s market value and the price of the stock?

Market value $

Price of the stock $

Which of the following statements is CORRECT?

a. LEAPS are very short-term options that were created relatively recently and now trade in the market.

b. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend.

c. Options typically sell for less than their exercise value.

d. Put options give investors the right to buy a stock at a certain strike price before a specified date.

e. Call options give investors the right to sell a stock at a certain strike price before a specified date

An option that gives the holder the right to sell a stock at a specified price at some future time is

a. a call option.

b. a naked option.

c. a put option.

d. an out-of-the-money option.

e. a covered option.

Suppose you believe that Delva Corporation’s stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put option giving you the right to sell 100 shares at a price of $85 per share. If you bought this option for $510.25 and Delva’s stock price actually dropped to $60, what would your pre-tax net profit be?

a. $2,193.70

b. $2,303.38

c. $1,989.75

d. $510.25

e. $2,089.24