Intermediate Financial Management Eugene F.- Brigham 11th Edition Test Bank

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Intermediate Financial Management Eugene F.- Brigham 11th Edition Test Bank

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CHAPTER 6
FINANCIAL OPTIONS

Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.

True/False

Easy:

(6.1) Options FP Answer: a EASY
. An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified period of time.

a. True
b. False

(6.1) Strike price FP Answer: a EASY
. The strike price is the price that must be paid for a share of common stock when it is bought by exercising a warrant.

a. True
b. False

(6.1) Exercise value FP Answer: a EASY
. The exercise value is the positive difference between the current price of the stock and the strike price. The exercise value is zero if the stocks price is below the strike price.

a. True
b. False

(6.1) Exercise value FP Answer: b EASY
. The exercise value is also called the strike price, but this term is generally used when discussing convertibles rather than financial options.

a. True
b. False

(6.1) Option time value FP Answer: a EASY
. As the price of a stock rises above the strike price, the value investors are willing to pay for a call option increases because both (1) the immediate capital gain that can be realized by exercising the option and (2) the likely exercise value of the option when it expires have both increased.

a. True
b. False

(6.1) Option pricing FP Answer: b EASY
. If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero value.

a. True
b. False

(6.1) Option pricing FP Answer: b EASY
. If the market is in equilibrium, then an option must sell at a price that is exactly equal to the difference between the stocks current price and the options strike price.

a. True
b. False

(6.1) Option pricing FP Answer: b EASY
. Since investors tend to dislike risk and like certainty, the more volatile a stock, the less valuable will be an option to purchase the stock, other things held constant.

a. True
b. False

(6.1) Option pricing FP Answer: b EASY
. Because of the time value of money, the longer before an option expires, the less valuable the option will be, other things held constant.

a. True
b. False

(6.1) Option pricing FP Answer: b EASY
. If we define the premium on an option to be the difference between the price at which an option sells and the exercise value (or the difference between the stocks current market price and the strike price), then we would expect the premium to increase as the stock price increases, other things held constant.

a. True
b. False

(6.6) Put-call parity FP Answer: b EASY
. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock, provided the strike prices for the put and call are the same.

a. True
b. False

Medium:

(6.6) Put-call parity FP Answer: b MEDIUM
. If a company announces a change in its dividend policy from a zero target payout ratio to a 100% payout policy, this action could be expected to increase the value of long-term options (say 5-year options) on the firms stock.

a. True
b. False

Multiple Choice: Conceptual

Easy:

(6.1) Option terms CP Answer: a EASY
. An option that gives the holder the right to sell a stock at a specified price at some future time is

a. a put option.
b. an out-of-the-money option.
c. a naked option.
d. a covered option.
e. a call option.

(6.1) Option value CP Answer: c EASY
. Other things held constant, the value of an option depends on the stocks price, the risk-free rate, and the

a. Variability of the stock price.
b. Options time to maturity.
c. All of the above.
d. None of the above.
e. Strike price.

(6.1) Option concepts CP Answer: e EASY
. Which of the following statements is most correct, holding other things constant, for XYZ Corporations traded call options?

a. The higher the strike price on XYZs options, the higher the options price will be.
b. 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.
c. If XYZs stock price stabilizes (becomes less volatile), then the price of its options will increase.
d. 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.
e. The price of these call options is likely to rise if XYZs stock price rises.

(6.1) Option concepts CP Answer: a EASY
. BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the following actions would decrease the value of the options, other things held constant?

a. The exercise price of the option is increased.
b. The life of the option is increased, i.e., the time until it expires is lengthened.
c. The Federal Reserve takes actions that increase the risk-free rate.
d. BLWs stock price becomes more risky (higher variance).
e. BLWs stock price suddenly increases.

(Comp: 6.1,6.3,6.4) Miscellaneous option concepts CP Answer: d EASY
. Which of the following statements is CORRECT?

a. Call options give investors the right to sell a stock at a certain strike price before a specified date.
b. Options typically sell for less than their exercise value.
c. LEAPS are very short-term options that were created relatively recently and now trade in the market.
d. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend.
e. Put options give investors the right to buy a stock at a certain strike price before a specified date.

Medium:

(6.1) Options CP Answer: c MEDIUM
. An investor who writes standard call options against stock held in his or her portfolio is said to be selling what type of options?

a. Put
b. Naked
c. Covered
d. Out-of-the-money
e. In-the-money

(6.1) Option value CP Answer: d MEDIUM
. Cazden Motorss stock is trading at $30 a share. Call options on the companys 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. The options with the $25 strike price have an exercise value greater than $5.
c. The options with the $35 strike price have an exercise value greater than $0.
d. If Cazdens stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5.
e. The options with the $25 strike price will sell for $5.

(6.1) Option value CP Answer: c MEDIUM
. Braddock Construction Co.s stock is trading at $20 a share. Call options that expire in three months with a strike price of $20 sell for $1.50. Which of the following will occur if the stock price increases 10%, to $22 a share?

a. The price of the call option will increase by more than $2.
b. The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%.
c. The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%.
d. The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%.
e. The price of the call option will increase by $2.

(Comp: 6.1,6.5,6.6) Miscellaneous option concepts CP Answer: e MEDIUM
. Which of the following statements is CORRECT?

a. Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be.
b. Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be.
c. Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be.
d. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.
e. If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit.

(Comp: 6.1,6.5,6.6) Miscellaneous option concepts CP Answer: c MEDIUM
. Which of the following statements is CORRECT?

a. Call options generally sell at a price less than their exercise value.
b. If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value.
c. Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, the lower the premium on the option is likely to be.
d. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.
e. 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.

Hard:

(6.1) Options CP Answer: c HARD
. Which of the following statements is CORRECT?

a. As the stocks 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 market value of an option depends in part on the options time to maturity and also on the variability of the underlying stocks price.
d. The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger.
e. An options value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option cant sell for more than its exercise value.

Multiple Choice: Problems

Easy:

(6.1) Call options CP Answer: b EASY
. Suppose you believe that Basso Inc.s stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $3.10 you can buy a 5-month call option giving you the right to buy 1 share at a price of $25 per share. If you buy this option for $3.10 and Bassos stock price actually rises to $45, what would your pre-tax net profit be?

a. -$3.10
b. $16.90
c. $17.75
d. $22.50
e. $25.60

(6.1) Put options CP Answer: b EASY
. Suppose you believe that Florio Companys stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $5.10 you could buy a 5-month put option giving you the right to sell 1 share at a price of $85 per share. If you bought this option for $5.10 and Florios stock price actually dropped to $60, what would your pre-tax net profit be?

a. -$5.10
b. $19.90
c. $20.90
d. $22.50
e. $27.60

Medium:

(6.2) Option price based on binomial model CP Answer: c MEDIUM
. 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 options value?

a. $2.43
b. $2.70
c. $2.99
d. $3.29
e. $3.62

(6.6) Put-call parity CP Answer: e MEDIUM
. 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. $7.33
b. $7.71
c. $8.12
d. $8.55
e. $9.00

Hard:

(6.5) Black-Scholes model CP Answer: c HARD
. An analyst wants to use the Black-Scholes model to value call options on the stock of Heath Corporation based on the following data:

The price of the stock is $40.
The strike price of the option is $40.
The option matures in 3 months (t = 0.25).
The standard deviation of the stocks returns is 0.40, and the variance is 0.16.
The risk-free rate is 6%.

Given this information, the analyst then calculated the following necessary components of the Black-Scholes model:

d1 = 0.175
d2 = -0.025
N(d1) = 0.56946
N(d2) = 0.49003

N(d1) and N(d2) represent areas under a standard normal distribution function. Using the Black-Scholes model, what is the value of the call option?

a. $2.81
b. $3.12
c. $3.47
d. $3.82
e. $4.20

CHAPTER 6
ANSWERS AND SOLUTIONS

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