1

Chapter 20 Options and Corporate Finance

Learning Objectives
1. Define a call option and a put option, and describe the payoff function for each of these options.

An option is the right, but not the obligation, to buy or sell an asset for a given price on or before a given date. The price is called the exercise or strike price, and the date is called the exercise date or expiration date of the option. The right to buy the asset is known as a call option. The payoff from a call option equals $0 if the value of the underlying asset is less than the exercise price at expiration. If the value of the underlying asset is higher than the exercise price at expiration, then the payoff from the call option is equal to the value of the asset value minus the exercise price. The right to sell the asset is called a put option. The payoff from a put option is $0 if the value of the underlying asset is greater than the exercise price at expiration. If the value is lower than the exercise price, then the payoff from a put option equals the exercise price minus the value of the underlying asset.

2.

List and describe the factors that affect the value of an option.

2 The value of an option is affected by five factors: the current price of the underlying asset, the volatility of the value of the underlying asset, the time left until the expiration of the option, the exercise price of the option, and the risk-free rate.

3.

Name some of the real options that occur in business, and explain why traditional NPV analysis does not accurately incorporate their values.

Real options that are associated with investments include options to defer investment, make follow-on investments, change operations, and abandon projects. Traditional NPV analysis is designed to make a decision to accept or reject a project at a particular point in time. It is not designed to incorporate potential value associated with deferring the investment decision. Incorporating the value of the other options into an NPV framework is technically possible but would be very difficult to do because the rate used to discount the cash flows would change over time with their riskiness. In addition, the information necessary to value real options using the NPV approach is not always available.

4.

Describe how the agency costs of debt and equity are related to options.

There are two principal classes of agency conflicts. The first is between stockholders and lenders. When there is a risk of bankruptcy, stockholders may have incentives to increase the volatility of the firms assets, turn down positive-NPV projects, or pay out assets in the form of dividends. Stockholders have these incentives because their payoff functions look like those for the owners of a call option.

3 The other principal class of agency conflict is between managers and owners. Managers tend to prefer less risk than stockholders and prefer to distribute fewer assets in the form of dividends because their payoff functions are more like those of lenders than those of stockholders. These preferences are magnified by the fact that managers are riskaverse individuals whose portfolios are not well diversified.

5.

Explain how options can be used to manage a firms exposure to risk.

A company can adjust its exposure to risks associated with commodity prices, interest rates, foreign exchange rates, and equity prices by buying or selling options. For example, a company that is concerned about the prices it will receive for products that will be delivered in the future can purchase put options to partially or totally eliminate that risk.

I.
1.

True or False Questions

A put option with a strike price of $20 is expiring today. The stock is currently selling at $25. Based on this information, the put option should not be exercised. a. b. True False

2.

A stock is selling for $50 today. A call option on the stock with a strike price of $50 is set to expire next month. If the price of the stock goes down tomorrow we would expect the price of the call option to go down as well.

4 a. b. True False

3.

A call option can sometimes be priced higher than the underlying asset. a. b. True False

4.

Neither a call nor a put option can have a negative price. a. b. True False

5.

The current price of an asset is $75. A put option on the asset with a strike price of $100 expires one year from now. It is possible, without arbitrage, for this put option to be priced at $24 today. a. b. True False

6.

If the risk-free rate of interest increases, all else being equal, we would expect the value of a call option to increase. a. b. True False

5 7. In the binomial pricing model, an option is priced using a replicating portfolio that typically consists of a risk-free bond and the asset underlying the option. a. b. True False

8.

To price an option using the binomial pricing model, it is important that we know the probability that the asset will increase in value. a. b. True False

9.

When using the binomial pricing model to price an option, the volatility of the underlying asset is represented by the difference between the two possible future values of the underlying asset. a. b. True False

10.

Consider a call option on a stock with a strike price of $60. If the stock price at expiration is $50, the payoff from the call option is $10. a. b. True False

11.

Consider a put option on a stock with a strike price of $60. If the stock price at expiration is $50, the payoff from the put option is $10.

6 a. b. True False

12.

Suppose you have sold a put option on a stock with a strike price of $25. If the stock price at expiration is $30, your payoff will be $5. a. b. True False

13.

A portfolio consisting of one put option and one call option, both with the same exercise price, is called a straddle. A straddle is a good investment strategy for investors who dont know whether an assets value is likely to go up or down, but think that the volatility of the asset will increase. a. b. True False

14.

If a project has a positive NPV, then the real options that affect the project are not important to estimating the value of the project. a. b. True False

15.

The option to defer investment can be characterized as the flexibility to wait and learn more information about a project before committing resources to the project. a. True

7 b. False

16.

Incorporating real options will not decrease the value of the project relative to the basic NPV analysis. a. b. True False

17.

After taking into account the value of real options, it is possible that some projects with a negative NPV should be pursued. a. b. True False

18.

A company is negotiating for the option to develop a platinum mine. Under the terms of the option contract, the company would be able to purchase the development rights to the mine one year from now for an exercise price specified today. If, during the negotiations over the option contract, the volatility of the price of platinum increases, the company should expect to pay a higher price for the development option. a. b. True False

19.

The option to abandon a project can decrease its value. a. b. True False

20.

Kelvins Thermostats Co. sells equipment to residential and commercial customers. It is considering whether or not to develop a new line of advanced commercial thermostats. The discounted cash flows from commercial thermostat sales are not likely to cover the development costs. However, the company has decided to pursue the project anyway. If the commercial technology is successful, it might be applied to a new line of very profitable residential thermostats. This is an example of the option to make follow-on investments. a. b. True False

21.

Consider a firm with a single loan. There are no interest payments on the loan, but the principal and interest are all due in two years. It is uncertain whether the cash flow the company will produce will be enough to pay off the debt. The payoff to stockholders in this company resembles a call option. a. b. True False

22.

Consider a company that is likely to go bankrupt in the next year. The bondholders may encourage the company to pursue risky negative-NPV projects in hopes that the firm will avoid financial distress. a. b. True False

23.

Consider a company that is likely to go bankrupt in the next year. Stockholders may wish to pursue negative-NPV projects, even if there is no additional value to the project from real options. a. b. True False

24.

By designing compensation plans with performance bonuses, stock-based compensation and stock options corporate boards are attempting to make the payoff function for managers look similar to the payoff function for stockholders. a. b. True False

25.

Financial options can be used to hedge risks such as interest rates and foreign exchange rates. a. b. True False

26.

Suppose the current spot price of wheat is $25 a bushel. A wheat farmer expects to produce 1,000 bushels at the end of the season, and she wants to ensure that she gets at least $19 a bushel. If a put option on 1,000 bushels of wheat with a strike price of $20,000 and an expiration date at the end of the season is selling for $1,000, the farmer can purchase the put option to guarantee she gets $19 a bushel.

10 a. b. True False

27.

Suppose the current spot price of corn is $20 a bushel. A corn farmer expects to produce 2,000 bushels at the end of the season, and she wants to ensure that she gets at least $18 per bushel. Call options on 1,000 bushels of wheat with a strike price of $15,000 and an expiration date at the end of the season are selling for $3,000. By selling call options on her corn crop, the farmer can guarantee that she gets at least $18 per bushel. a. b. True False

28.

Hedging is the process of using financial instruments such as options, forwards, futures, and swaps to reduce the financial risks faced by a firm. a. b. True False

29.

Socrates Motor Co. has a defined-benefit pension plan for its employees. To fund the plan, the company makes periodic contributions to a stock investment fund. If the stock market declines significantly, the company would have to make additional contributions to make up for lost revenue. The company could hedge its risk of a market downturn by periodically purchasing put options on the stock market. a. b. True False

11

30.

A small soybean farmer wants to hedge the price risk of his next crop, but he is financially constrained. He cant raise capital by either borrowing money or selling his current assets. Instead, he sells call options on his soybean crop with a strike price of $14 per bushel at a premium of $0.50 a bushel. Using the process from selling the call options, he buys put options on his soybean crop with a strike price of $11.00 per bushel at a premium of $0.35 per bushel. The risk-free interest rate is 0 percent. By taking these derivative positions, the farmer has guaranteed that he will earn somewhere between $14.15 and $11.15 per bushel. a. b. True False

12

II.

Multiple-Choice Questions and Problems

31.

An investor (the buyer) purchases a call option from a seller. On the expiration date of a call option, a. the buyer has the obligation to buy the underlying asset and the seller has the obligation to sell it. b. the buyer has the right to buy the underlying asset and the seller has the obligation to sell it. c. the buyer has the obligation to buy the underlying asset and the seller has the right to sell it. d. None of the above.

32.

An investor (the buyer) purchases a put option from a seller. On the expiration date of a call option, a. the buyer has the obligation to sell the underlying asset and the seller has the right to buy it. b. the buyer has the obligation to sell the underlying asset and the seller has the obligation to buy it. c. the buyer has the right to sell the underlying asset and the seller has the obligation to buy it. d. None of the above

33.

Which one of the following statements is NOT true?

13 a. b. The value of a call option can never be negative. The value of a call option can never be more than the value of the underlying asset. c. The value of a call option can never be worth less than the current value of the asset minus present value of the strike price. d. The value of a call option can never be worth more than the strike price.

34.

Which one of the following statements is NOT true? a. b. c. The value of a put option can never be negative. The value of a put option can never be worth more than the underlying asset. The value of a put option can never be less than the present value of the strike price minus the current value of the underlying asset. d. All the above statements are true.

35.

Suppose you own a call option on a stock with a strike price of $20 that expires today. The price of the underlying stock is $15. If you exercise the option and immediately sell the stock, a. b. c. d. you will earn $5. you will lose $5. you will lose $15. you will earn $15.

14 36. Suppose you own a put option on a stock with a strike price of $35 that expires today. The price of the underlying stock is $25. If you purchase the stock and exercise the put option, a. b. c. d. you will earn $10. you will lose $10. you will earn $25. you will lose $25.

37.

Consider an option that gives the owner the right to buy a stock for $20 only on the third Friday of May, next year. The option being described is a. b. c. d. an American call option. a European put option. an American put option. a European call option.

38.

Consider an American and a European call option on a dividend-paying stock, with otherwise identical features (same strike price, etc.). Which one of the following statements is true? a. b. c. d. The American call option will never be worth less than the European call option. The European call option will never be worth less than the American call option. Both options should always have the same value. None of the above statements is true.

15 39. A straddle is a combination of a put option and a call option on the same asset with the same strike price. Which one of the following statements about a straddle is NOT true? a. The owner of a straddle will receive a payoff if the price of the underlying asset is higher than the strike price at expiration. b. The owner of a straddle will receive a payoff if the price of the underlying asset is lower than the strike price at expiration. c. The owner of a straddle will never exercise the put and the call option at the same time. d. The owner of a straddle will receive a higher payoff if the price of the underlying asset at expiration is near the strike price.

40.

Which of the following changes, when considered individually, will increase the value of a call option? a. b. c. d. The value of the underlying asset becomes more volatile. The price of the underlying asset goes down. Getting closer to the expiration date (the passage of time). A higher strike price.

41.

Which of the following changes, when considered individually, will increase the value of a put option? a. b. c. An increase in the risk-free interest rate Lower volatility of the price of the underlying asset A higher strike price

16 d. None of the above

42.

What happens to the value of call and put options if the volatility of the price of underlying asset decreases? a. b. c. d. Put options will be worth more, call options will be worth less. Put options will be worth less, call options will be worth more. Both call and put options will be worth more. Both call and put options will be worth less.

43.

If the price of the underlying asset increases, what happens to the value of call and put options? a. b. c. d. Put options will be worth more, call options will be worth less. Put options will be worth less, call options will be worth more. Both call and put options will be worth more. Both call and put options will be worth less.

44.

With everything else constant, as the expiration date gets closer, what happens to the value of call and put options? a. b. c. d. Call option will be worth more, put options will be worth less. Call option will be worth less, put options will be worth more. Both call and put options will be worth more. Both call and put options will be worth less.

17 45. With everything else held constant, what happens to the value of call and put options if the risk-free interest rate increases? a. b. c. d. Call options will be worth more, put options will be worth less. Call options will be worth less, put options will be worth more. Both call and put options will be worth less. Both call and put options will be worth more.

46.

The management at Socrates Motors considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to be easily converted to manufacture other types of large machinery. If their new line of cars is poorly received, their plant should be easy to sell to another manufacturing company. In this example, the price at which they expect to sell the plant if things go poorly resembles a. b. c. d. the premium of a put option on the plant. the premium of a call option on the plant. the strike price of a put option on the plant. the strike price of a call option the plant.

47.

Socrates Motors is very likely to enter financial distress. Without a dramatic change of events over the next couple of years, the company will be unable to pay its lenders, who will then gain control of the companys assets. A group of stockholders has pressured the companys management to begin manufacturing and selling one of the companys concept cars in the hope that it will be a big hit. Concept cars are prototypes that are developed to test new ideas and to show off at auto shows. Although elements of concept

18 cars are often incorporated into product lines, rushing a concept car into production is very risky. The best estimates about the concept car make it appear to be a negative-NPV project. This is a good example of a. b. c. d. the dividend payout problem. the underinvestment problem. the asset substitution problem. the agency cost of equity.

48.

Consider a CEO who holds neither stock nor stock options in the company she runs. Her payoff function regarding the firms performance is most likely to resemble a. b. c. d. stockholders. lenders. owners of a call option on the firm. holders of a risk-free bond with coupon payments equal to her salary.

49.

Which of the following compensation methods is NOT likely to reduce agency costs between stockholders and managers? a. b. Stock compensationgiving the CEO stock in the company as part of her salary. A golden parachutea guaranteed large lump-sum payment in the event that the CEO is fired. c. d. A higher salary than that of other CEOs in similar companies. Performance bonusesa higher bonus if the companys cash flows are higher then expected.

19

50.

Which of the following reasons is NOT a valid explanation of why managers sometimes choose to take on negative-NPV Projects: a. The NPV analysis does not include a valuable real option to expand the project if things go well. b. If the firm has debt, managers may create value for shareholders by taking on some risky negative-NPV projects. c. Managers payoff functions represent the payoffs of lenders. By taking negativeNPV projects, the managers can create value for lenders. d. All of the above descriptions are valid explanations for why managers sometimes take on negative NPV projects.

51.

As the manager of a sporting goods company, you are presented with a new golf project. An inventor has recently patented the design for a new golf club that makes playing golf much easier. Your company has made contact with the inventor, who is willing to sell the exclusive rights to the technology, but if you dont act fast he will sell the rights to a rival company. You are not certain whether the new golf club will become popular, but your analysts have completed a basic NPV analysis. Given the available information, the project has a positive NPV. However, you know there are several real options associated with the project, including the option to abandon the project and the option to make follow-on investments. Which one of the following statements regarding the project is correct?

20 a. Based on the NPV analysis, you should accept the project. The value of the project may be worth more than the NPV analysis but not less. b. Based on the NPV analysis, you should accept the project. The NPV analysis contains all the information about the value of the project. c. Based on the NPV analysis, you should reject the project. Without additional information about the value of the real options, there is no way to make a decision. d. Based on the NPV analysis, you should reject the project. The NPV analysis contains all the information about the value of the project.

52.

A start-up company is making a decision on whether to develop a new internet social networking site. The site will cost $1 million to develop, but it is unclear whether the new technology critical to the site will work correctly. If development is successful, it will cost an additional $20 million next year to advertise the site to Internet users. If the site becomes popular with Internet users, it is expected to generate a present value of $100 million in advertising revenue. There is a 10 percent chance that the site will be both successfully developed and subsequently become popular with Internet users. The companys cost of capital is 15 percent. Should the company pursue the project? a. b. c. d. No, the project has a negative NPV. Yes, the project has a positive NPV. It doesnt matter. The project has zero NPV. There is not enough information to make a decision.

21 53. The employment contracts for professional athletes often contain options for either the player or the team. Consider one recent contract in Major League Baseball. The players salary was guaranteed for the first couple years. However, after several years, the team had the option to cancel the contract if the player became injured. If we think of each player as a project for the team, this option feature of the contract is best described as a. b. c. d. the option to defer investment. the option to make follow-on investments. the option to change operations. the option to abandon projects.

54.

RealEstates LLP is considering the construction of a new development of condominiums in downtown Austin, Texas. The site for the new development is currently occupied by an office building owned by the city. The projects profitability will depend largely on the population increase in Austin over the next several years. Rather than buy the site, RealEstates has entered into an agreement with the city to pay $200,000 for the right to purchase the site for $10 million two years from now. The real option embedded in this contract is best described as a. b. c. d. the option to defer investment. the option to make follow-on investments. the option to change operations. the option to abandon projects.

22 55. Consider a new firm that is working on the first generation of long-awaited consumer jet packs. The project will take a tremendous amount of R&D expenditure. Even if the development is successful, manufacturing the first generation of jet packs is likely to be so expensive that only a select few consumers will be able to afford them. The projected sales of the first generation of jet packs almost certainly wont cover the development and manufacturing coststhe project has a negative NPV. Which of these reasons would validate the firms decision to pursue the jet pack project? a. If development is unsuccessful, it can abandon the project before spending money on manufacturing. b. If the project is successful, it may lead to a very profitable second projecta cheaper jet pack that will be a positive-NPV project. c. Because it is a high-tech firm, the cash flows generated by a project are not important to valuing the company. d. None of these reasons support the decision to pursue the project.

56.

A local city government has awarded a contract to sequentially build five new elementary schools over the next 10 years. The price for each school has been spelled out in the contract, but at the beginning of each year the city can cancel the order for the remaining schools. The city government is concerned that if the population of the town does not grow as expected it may not need all of the schools. What sort of financial option does the option to cancel the order resemble? a. Owning a call option on the value of the new schools b. Owning a put option on the value of the new schools

23 c. Selling a call option on the value of the new schools d. Selling a put option on the value of the new schools

57.

Purchasing a house is a somewhat complicated process. Typically, if the buyers offer is accepted by the seller, the transaction will not be completed or closed for several weeks. During this time the buyer may gather more information about the house or research other houses in the area. Some home purchase contracts include an option fee. The buyer may pay the seller a few hundred dollars for the right to walk away from the contract prior to closing for any reason. This option fee is best described as a. the option to defer investment. b. the option to make follow-on investments. c. the option to change operations. d. a put option on the house.

58.

The management at Socrates Motors considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to easily be converted to manufacture other types of large machinery. If their new line of cars is poorly received, their plant should be easy to sell to another manufacturing company. In this example, the extra cost of building the plant in such a way that it can easily be converted for other uses resembles a. b. c. the premium of a put option on the plant. the premium of a call option on the plant. the strike price of a put option on the plant.

24 d. the strike price of a call option on the plant.

59.

Franklin Foods has made the decision to invest in a new line of organic microwave dinners. The new line of dinners is a negative-NPV project; paying its suppliers to convert to organic practices will be expensive. However, the company will be in a good position to expand into more profitable lines of food if consumer demand for organic foods grows more then expected. The negative value of the organic dinner project most closely resembles: a. b. c. d. the premium of a put option on future organic projects. the premium of a call option on future organic projects. the strike price of a put option on future organic projects. the strike price of a call option on future organic projects.

60.

Gnu Homes, Inc., is a developer of planned residential communities. It has entered into an option contract with a land owner outside Austin, Texas. It will pay the land owner $100,000 for the option to buy the land in two years at a price of $20 million. During that time Gnu Homes will evaluate population and real estate trends in Austin. Their plan is to buy the land if real estate prices in Austin increase enough that developing the land would be worth more then the $20 million price. The $20 million purchase price resembles a. b. c. the premium price of a put option on the land. the premium price of a call option on the land. the strike price of a put option on the land.

25 d. the strike price of a call option on the land.

61.

The claim stockholders hold on cash flows in a company with outstanding debt is often described as a. b. c. d. a call option on the firms assets. a put option on the firms assets. an interest-free bond with the same value as the firms assets. none of the above

62.

Which of the following statements is NOT an example of the agency cost of debt? a. ABC Co. shareholders pressure management to invest in very risky projects in hopes that one of the investments might pay off. The company is highly leveraged, so shareholders have little to lose. b. ABC Co. has a large amount of debt but very few investment opportunities. The board of directors decides to pay out a large special dividend, and the company subsequently enters bankruptcy. Lenders collect about 60 percent of the face value of the debt. c. ABC Co. is very close to financial distress. The company has a positive-NPV investment opportunity, but even with the project the company is likely to enter bankruptcy. Investors refuse to invest the additional funds necessary to pursue the project, even though it has a positive NPV. d. Investors are unsure of the value for ABC Co. ABC Co. decides to issue equity to pay down debt. The market assumes that ABC Co.s managers are issuing equity

26 because they think that the companys stock is overvalued. As a result, the companys stock price falls when the equity issue is announced.

63.

The claim lenders hold on cash flows in a company with outstanding risky debt is often thought of as a. b. c. d. holding a call option on the firms assets. holding a put option on the firms assets. selling a put option on the firms assets and holding a risk-free bond. selling a call option on the firms asset and holding a risk-free bond.

64.

Adding stock options and bonuses for performance to the compensation of a manager is intended to closer align the interest of the manager with a. b. c. d. stockholders. lenders. employees. none of the above.

65.

Option payoffs: What is the payoff for a call option with a strike price of $45 if the underlying stock price at expiration is $75? a. b. c. d. $30 $45 $75 None of the above

27

66.

Option payoffs: What is the payoff for a call option with a strike price of $30 if the underlying stock price at expiration is $25? a. b. c. d. $5 $25 $30 None of the above

67.

Option payoffs: What is the payoff for a put option with a strike price of $65 if the underlying stock price at expiration is $33? a. b. c. d. $0 $33 $32 $65

68.

Option payoffs: You own a put option on ABC. Co. stock with a strike price of $40. The current stock price is $40. You will benefit if a. the stock price goes up. b. the stock price goes down. c. the stock price stays the same. d. It doesnt matter; you are indifferent to changes in the stock price.

28 69. Option payoffs: You have sold a call option on ABC Co. stock with a strike price of $40. You do not intend to make any other transactions before the options expiration date. The current stock price is $20. Which of the following statements best describes your hopes for the stock? a. You want the stock price to fall. b. You want the stock price to rise. c. You are indifferent, as long as the stock price stays under $40. d. It doesnt matter; you are indifferent to changes in the stock price.

70.

Option payoffs: What is the payoff for a put option with a strike price of $20 if the price of the underlying stock at expiration is $18? a. b. c. d. $0 $2 $18 $20

71.

Option valuation: Consider a call option with a strike price of $20, which expires in one year. The risk-free rate of interest is 5 percent. The underlying stock price is $30. Without arbitrage, which of the following is a possible price for the call option? a. b. c. d. $0 $8 $15 None of the above

29

72.

Option valuation: Consider a call option with a strike price of $10, which expires in one year. The risk-free rate of interest is 10 percent. The current underlying stock price is $30. Without arbitrage, which of the following is a possible price for the call option? a. b. c. d. $0 $20.50 $21.00 None of the above

73.

Option valuation: Consider a put option with a strike price of $40, which expires in one year. The risk-free rate of interest is 8 percent. The current underlying stock price is $20. Without arbitrage, which of the following is a possible price for the put option? a. b. c. d. $0.50 $16.50 $25.00 None of the above

74.

Option payoffs: Kelvins Thermostats, Inc., stock is currently trading at $20 per share. There are two types of options written on the stock. Call options with a strike price of $15, which expire next month, are currently trading at $6.00. Put options with a strike price of $15 which expire next month are currently trading at $1.00. Steve invests $120 in common stock. Carol invests $120 in the call options. Paul invests $120 in the put

30 options. At the end of one month, the price of Kelvins Thermostats, Inc., is $23. Who made the most money off of their investment? a. b. c. d. Steve Carol Paul Steve and Carol Tied

75.

Option payoffs: Haumer Hardware Co. stock is currently trading at $20. There are two types of options written on the stock. Call options with a strike price of $20, which expire next year, are currently trading at $8. Put options with a strike price of $20, which expire next year, are currently trading for $2. Steve invests $120 in common stock. Carol invests $120 in the call options. Paul invests $120 in the put options. At the end of one year the price of Haumer Hardware Co. stock is $18. Who made the most money off of their investment? a. b. c. d. Steve Carol Paul Steve and Carol tied

76.

Binomial pricing: Assume that the stock of Malcolms Mufflers, Inc,. is currently trading for $18 and will either rise to $20 or fall to $14 in one year. The risk-free rate for one year is 10 percent. What is the value of a call option with a strike price of $15? a. $4.39

31 b. c. d. $3.33 $2.04 $0.83

77.

Binomial pricing: Assume that the stock of Malcolms Mufflers, Inc., is currently trading for $43 and will either rise to $55 or fall to $17 in one year. The risk-free rate for one year is 8 percent. What is the value of a call option with a strike price of $45? a. b. c. d. $4.40 $5.84 $6.84 $7.17

78.

Binomial pricing: ABC, Inc., stock is currently trading for $45 and will either rise to $47 or fall to $42 in one year. The risk-free rate for one year is 5 percent. You own a call option with a strike price of $30, which expires in one year. What is the value of your call option? a. 0 b. 2.27 c. 12.05 d. 16.43

32 79. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $17 and will either rise to $23 or fall to $12 in one year. The risk-free rate for one year is 10 percent. What is the value of a call option with a strike price of $25? a. b. c. d. $0 $6.23 $5.72 None of the above

80.

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $22 and will either rise to $31 or fall to $18 in one year. The risk-free rate for one year is 0 percent. What is the value of a put option with a strike price of $25? a. b. c. d. $0 $1.85 $3.00 $4.85

81.

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $44 and will either rise to $50 or fall to $29 one year. The risk-free rate for one year is 4 percent. What is the value of a put option with a strike price of $40? a. b. c. d. $0 $2.14 $3.14 $5.54

33

82.

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $16 and will either rise to $23.50 or fall to $9 in one year. The risk-free rate for one year is 3 percent. What is the value of a put option with a strike price of $18 that expires in three months? a. b. c. d. $0 $2.75 $4.23 $5.73

83.

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $29 and will either rise to $32 or fall to $5 in one year. The risk-free rate for one year is 2 percent. What is the value of a put option with a strike price of $30? a. b. c. d. $0 $0.41 $1.78 $2.20

84.

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $18 and will either rise to $30 or fall to $12 in one year. The risk-free rate for one year is 0 percent. What is the value of a put option with a strike price of $15? a. b. $0 $2

34 c. d. $5 $6

85.

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $2.60 and will either rise to $10 or fall to $0 in one year. The risk-free rate for one year is 1 percent. What is the value of a put option with a strike price of $5? a. b. c. d. $0 $2.35 $3.65 $3.70

86.

Binomial pricing: You own a share of common stock in ABC, Inc., which is currently trading for $18 and will either rise to $30 or fall to $12 in one year. The risk-free rate for one year is 0 percent. You also own an American put option on the stock with a strike price of $20, which expires in one year. What is the value of the put option, and what would be the net payoff from exercising the option now? a. b. c. d. Option Value: $3.33 Net Payoff $2 Option Value: $3.33 Net Payoff $6 Option Value: $5.33 Net Payoff $2 Option Value: $5.33 Net Payoff $6

87.

Binomial pricing: You are fortunate enough to own a put option with a strike price of $50 on the stock of ABC, Inc. The current stock price is $4. When the option expires, you

35 expect the stock price to be either $2 or $5. The risk-free rate of interest is zero. What is the value of your option? a. 0 b. 45 c. 46 d. 48

88.

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $16 and will either rise to $18 or fall to $12 in one year. The risk-free rate for one year is 1 percent. What is the value of a put option with a strike price of $10? a. b. c. d. $0 $2.00 $2.33 $5.00

89.

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $21 and will either rise to $30 or fall to $18 in one year. The risk-free rate for one year is 0 percent. You own a portfolio that consists of one call option and one put option. Both options have a strike price of $25, and both expire in one year. What is the value of your portfolio? a. b. c. $0 $25.00 $6.00

36 d. $6.50

90.

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $16 and will either rise to $50 or fall to $2 in one year. The risk-free rate for one year is 8 percent. You own a portfolio that consists of one call option and one put option. Both options have a strike price of $15, and both expire in one year. What is the value of your portfolio? a. b. c. d. $0 $15 $21.40 $18.52

91.

Binomial pricing: Consider two call options written on different stocks. Both call options have a strike price of $15 and expire one year from today. The first option is written on LowVol Co., whose current stock price is $16. One year from now, shares of LowVol Co. will either rise to $18 or fall to $14. The second option is written on HighVol, Inc., whose current stock price is also $16. One year from now shares of HighVol Inc. will either rise to $22, or fall to $0. The risk-free interest rate is 0 percent. Which call option is worth more? a. b. c. d. The call option on LowVol is worth more. The call option on HighVol is worth more. They are both worth the same amount. There is not enough information to make a comparison.

37

92.

Binomial pricing: Consider a call option and a put option both written on ABC, Inc. stock. Both options have a strike price of $20 and expire in one year. The stock of ABC, Inc., is currently selling for $20. In one month the stock will be at either $24 or $18. The risk-free rate is 0 percent. Which is worth more, the put option or the call option? a. b. c. d. The put option is worth more. The call option is worth more. They are worth the same. There is not enough information.

93.

Combining options: Suppose you are creating a portfolio that consists of zero-interest bonds, stock from a single company, and call and put options on the stock. Holding which of the following combination of securities will give the payoff shown in the following diagram?

Value

$20

$40

$60

$80

Stock Price

38 a. b. Buy one call option and one put option on the stock with a strike price of $60. Buy one call option with a strike price of $60 and sell short one call option with a strike price of $80. Buy one put option at a strike price at $60 and sell short one put option with a strike price of $40. c. Buy one share of the underlying stock. In addition, buy two call options, one with a $40 strike price, and one with a $80 strike price. d. Buy one share of the underlying stock, and a put option with a strike price of $60. Sell short call two call optionsone with a strike price of $40 and one with a strike price of $80.

94.

Combining options: Suppose you are creating a portfolio that consists of zero-interest bonds, stock from a single company, and call and put options on the stock. Holding which of the following combination of securities will give the payoff shown in the following diagram?

Value

$20

$60

$80

Stock Price

a.

Buy $20 in risk-free bonds, and sell short one call option with a strike price of $60.

b. c.

Buy $20 in risk-free bonds, and buy one put option with a strike price of $60. Buy one share of stock, and buy one call option with a strike price of $60.

39 d. Buy one share of stock, and sell one put option with a strike price of $60.

95.

Combining options: Suppose you are creating a portfolio that consists of zero-interest bonds, stock from a single company, and call and put options on the stock. Holding which of the following combination of securities will give the payoff shown in the following diagram?

Value $60

Stock Price $60 $120

a.

Buy one put option of the stock with a strike price of $60. Sell short a call option with a strike price of $120.

b.

Buy $60 in zero-interest bonds. Sell short one call option with a strike price of $60. Sell short one put option with a strike price of $60.

c. d.

Buy one share of stock. Sell one call option with a strike price of $120. Buy one share of the stock. Sell short two call options with a strike price of $60. Buy one call option with a strike price of $120.

96.

Combining options: Suppose you are creating a portfolio that consists of zero-interest bonds, stock from a single company, and call and put options on the stock. Holding

40 which of the following combination of securities will give the payoff shown in the following diagram?
Value

$40

$40

$80

Stock Price

a.

Buy one call option with a strike price of $40 and one put option with a strike price of $80.

b.

Buy one call option with a strike price of $80 and one put option with a strike price of $40.

c.

Sell one call option with a strike price of $40 and one put option with a strike price of $80.

d.

Sell one call option with a strike price of $80 and one put option with a strike price of $40.

97.

Risk management: OilDog Co. is a privately owned oil drilling and hot dog producing company with a significant amount of debt. Most of the companys cash flows come from the very safe hot dog unit of the business. With only the assets in place, the company is very likely to avoid financial distress for the foreseeable future. Avoiding financial distress is very important to the owners, who founded the company. The company is considering a new oil field project, determined to have a positive NPV. Because of the nature of oil prices, the project is very risky. At any oil price above $110 the project would add value to the company. However, if oil prices were to fall below $90

41 the losses could push the entire business into financial distress. The risk-free interest rate is 0 percent. Which one of the following strategies would allow the firm to pursue the positive-NPV project while hedging the oil price risk? a. The firm purchases call options with a strike price of $120 for each barrel of oil it expects to produce. Each call option costs $5. b. The firm sells call options with a strike price of $120 on each barrel of oil it expects to produce. Each option costs $5. c. The firm purchases put options with a strike price of $120 on each barrel of oil it expects to produce. Each option costs $5. d. The firm sells put options with a strike price of $120 on each barrel of oil it expects to produce. Each option costs $5.

98.

Risk management: Consider a wheat farmer who expects to produce 50,000 bushels of wheat at the end of this season. To hedge the risk associated with wheat prices, the farmer purchases put options to cover his entire crop. The put options have a strike price of $7.50 per and a premium of $0.30 per bushel. He also sells an equal amount of call options with a strike price of $7.50 per bushel and a premium of $0.43 a bushel. Which of the following statements is NOT correct? a. b. c. From this transaction the farmer can pocket $6,500 immediately. If wheat prices go up substantially, the farmer will earn more money. The put options guarantee that the farmer will receive at least $7.50 per bushel at the end of the season. d. The farmer has guaranteed that he will sell his wheat for $7.50 a bushel.

42

99.

Real options: Consider a lease agreement recently offered by a car dealership. The agreement gives the customer the right to use a new SUV for three years in exchange for payments of $550 per month. At the end of the lease, the customer can choose to purchase the SUV for $15,000. What sort or option does this resemble? a. b. c. d. A put option on the SUV with a strike price of $15,000 A call option on the SUV with a strike price of $15,000 A put option on the SUV with a strike price of $19,800 A call option on the SUV with a strike price of $19,800

100.

Risk management: CoolHaus, Inc., is a manufacturer of residential air conditioning equipment. Air conditioning equipment requires a lot of copper. In six months the company will purchase its copper supply for the next two years. Management is very concerned about the volatility of copper prices. Assume the risk-free rate of interest is 0 percent. Which of the following transactions will ensure the company does not have to pay more then $8,100 per ton of copper six months from now? a. The company purchases a put option for the necessary amount of copper with a strike price of $8,000 per ton, a premium of $100 per ton, and an expiration date six months from now. b. The company purchases a call option for the necessary amount of copper with a strike price of $8,000 per ton, a premium of $100 per ton, and an expiration date six months from now.

43 c. The company sells a put option for the necessary amount of copper with a strike price of $8,000 per ton, a premium of $100 per ton and an expiration date six months from now. d. The company sells a call option for the necessary amount of copper with a strike price of $8,000 per ton, a premium of $100 per ton, and an expiration date six months from now.

44

III. Essay Questions

101.

Describe the difference between American call options and American put options. Include in your answer a description of the option premium, the option strike price, the expiration date, and the payoff function.

Answer: The buyer of an American call option pays the seller a premium for the right to purchase the underlying asset at the strike price, before or on the expiration date. Because the buyer of the option has the right, but not the obligation, to purchase the asset, he will only exercise the option if the asset is worth more than the strike price. The payoff function for a call option is zero until the value of the underlying asset reaches the strike price. If the price of the underlying asset is above the strike price, the payoff function is equal to the difference between the asset price and the strike price. The buyer of an American put option pays the seller a premium for the right to sell the underlying asset at the strike price, before or on the expiration date. Because the buyer of the option has the right, but not the obligation, to sell the asset, he will only exercise the option if the asset is worth less than the strike price. The payoff function for a put option is zero if the value of the underlying asset is higher than the options strike price. If the value of the underlying asset is lower than the strike price, the payoff of the put option is equal to the difference between the strike price and the underlying asset price.

45 102. Name the factors that affect the value of a call option and explain the direction of the effects.

Answer: Five factors affect the value of a call option. The Strike Price of the OptionAll else equal, the lower the strike price of the call option, the more valuable the option is. This is true because with a low strike price, the underlying asset price will not have to be as high for the option to be in the money. The Price of the Underlying AssetAll else equal, the higher the price of the underlying asset, the more valuable a call option on the asset is. If the price of the underlying asset is higher, it is more likely to be above the strike price at the expiration date. The Volatility of the Underlying AssetAll else equal, the higher the volatility of the price of an asset, the more a call option is worth. With higher volatility, the price of the underlying asset has a higher chance of going significantly down or up before the expiration date. Because the call option will only be exercised if the underlying asset price is above the strike price, the benefits from the upside of volatility outweigh the negatives from the downside of volatility. Time until Expiration of the OptionAll else equal, the longer until an option expires, the more it is worth. The effect of the time until expiration is similar to the effect of volatility. With more time until maturity, the price of the underlying asset is more likely to significantly increase or decrease. The Risk-Free Interest RateThe value of a call option increases with the risk-free interest rate. The present value of the strike price decreases with the risk-free rate.

46 Since a call option involves paying the strike price in the future, a higher risk-free rate increases the value of the option.

103.

Youre brought in to consult on a project for Object Steel Corp., which is

considering whether or not to build a new high-tech manufacturing facility. Give four examples of real options that you would consider when evaluating the project.

Answer: Real options fall into four categories: options to defer investment, options to change operations, options to abandon projects, and to make follow-on investments. Many examples of real options might be included in this steel project. The following list gives one example from each category of real option. The option to defer investment. The firm may consider postponing the project until it has more information about the costs and benefits of the project. For example, the company may learn that the plant will be less profitable then expected. Suppose that during the next year costly environmental regulations are enacted, or the price of steel goes down. The company should take these considerations into account when deciding if now is the best time to build the plant. The option to change operations. The company must consider whether it will have the flexibility to change the way the plant is operated. For example, if the demand for steel falls, it might be able shut down the plant temporarily and reduce costs. Alternatively, it might be able to produce other metals, such as bronze or brass, if it becomes more profitable to do so.

47 The option to abandon the project. The company should consider what it might be able to do with the project if it fails or it becomes unprofitable to continue. It might decide to construct the facility in such a way that it can accommodate other manufactures in the event it has to liquidate the plant. The option to make follow-on investments. The firm should consider whether any followon investments may spring from this project. For example, it might consider whether it can expand the plant to increase production if demand for steel is high. It might also consider whether the new production process might be retrofitted to its existing plants, if the project is successful.

104.

What are agency costs in corporate finance, and how do they relate to options?

Answer: Agency costs arise when the interests of stockholders, lenders, and managers are not perfectly aligned. These costs often arise because the payoff functions for these different claimholders look like different types of options. One broad category is the agency costs of debt. When the firm has debt, the payoff function of stockholders looks similar to a call option on the firms assets. The face value of debt is similar to the strike price on a call option. Because of this option-like payoff function, the stockholders have an incentive to take actions that increase the value of the stockholders claim, but may reduce the total value of the firm. Examples of agency problems from debt include the dividend payout problem, the asset substitution problem, and the underinvestment problem.

48 Another broad category of agency costs is the agency costs of equity. This describes the difference between the interests of stockholders and managers. The payoff function for a salary-only manager is similar to a portfolio consisting of a risk-free bond and a put option. If the company performs well, the manager is not likely to see much additional benefit. However, if the company enters financial distress, the manager is likely to be fired and lose much of his or her future wealth. This option-like payoff gives the managers an incentive to avoid risky projects that might increase the probability of financial distress, even if the project has a positive NPV. Turning down positive-NPV projects reduces the total value of the firm. Often the compensation for senior managers contains additional payoffs for good performance to more closely align their incentives with those of shareholders.

49

IV. Answers to True or False Questions

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. True True False True True True True False True False True False True False True True True True False True True False

50 23. 24. 25. 26. 27. 28. 29. 30. True True True True False True True True

51

V.
31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52.

Answers to Multiple-Choice Questions

b c d b b a d a d a c d b d a c c b c c a d

52 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71. 72. 73. 74. 75. d a b a a a b d a d c a a d c b c b c c c b c

53 76. 77. 78. 79. 80. 81. 82. 83. 84. 85. 86. 87. 88. 89. 90. 91. 92. 93. 94. 95. 96. 97. 98. a d d a d b c d b c c c a d d b c b a d b c b

54 99. 100. b b

55

VI. Solutions to Multiple-Choice Problems

71. Solution: Without arbitrage, the value of the option must fall between $10.96 and $30. Out of the given choices, only $15 is a possible price for the option.

Value of Call Option

$30

The four limits tell us that the value of a call option prior to expiration will actually fall within this shaded area.

$10.96

$0 PV of Strike Price = 20/1.05 = $19.04 $30

Current Value of Underlying Asset

72. Solution: Without arbitrage, the value of the option must fall between $20.91 and $30. Out of the given choices, only $21 is a possible price for the option.

56
The four limits tell us that the value of a call option prior to expiration will actually fall within this shaded area.

Value of Call Option

$30

$20.91

$0 PV of Strike Price = 10/1.10 = $9.09 $30

Current Value of Underlying Asset

73.

Solution: Without arbitrage, the value of the put option must fall between $17.04 and $19.04. Out of the given choices, only $25 is a possible price for the option.

Value of Put Option $37.04

The limits tell us that the value of a put option prior to expiration will actually fall within this area.

$17.04

$0 $20 PV of Strike Price = 40/1.08 = $37.04

Current Value of Underlying Asset

57

74.

Solution: Steve holds ($120) / ($20) per share = 6 shares of stock. His gain is (6 shares) x ($23 per share) $120 = $18 Carol holds ($120) / ($6 per call option) = 20 call options. The final price of the stock is above the $15 strike price, so her options are in the money. Her gain is ($23 $15) x (20 call options) $120 = $40 Paul holds ($120) / ($1 per put option) = 120 put options. The final price of the stock is above the $15 strike price, so his options are out of the money. He received no payoff. His loss is $120. Carol made the most money.

75.

Solution:

Steve holds ($120) / ($20) per share = 6 shares of stock. The stock went down, so Steve lost money. His loss is (6 shares) ($18 per share) $120 = $12. Carol holds ($120) / ($8 per call option) = 15 call options. The final price of the stock is below the $20 strike price, so her options are out of the money. There is no payoff from her call options. Her loss is $120. Paul holds ($120) / ($2 per put option) = 60 put options. The final price of the stock is below the $20 strike price, so his options are in the money. His gain is ($20 $18) (60) $120 = 0. Paul broke even, the others lost money.

58 76. Solution: The payoff from the call option is $5 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $5 = ($20 x) + (1.10 y) $0 = ($14 x) + (1.10 y) x = 0.83 shares of stock y = $10.51 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.83 $18) + (10.51) = $4.39

77.

Solution: The payoff from the call option is $10 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $10 = ($55 x) + (1.08 y) $0 = ($17 x) + (1.08 y) x = 0.263 shares of stock y = $4.14 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.263 $43) + (4.14) = $7.17

78.

Solution:

59 The payoff from the call option is $17 if the stock price rises and $12 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $17 = ($47 x) + (1.05 y) $12 = ($42 x) + (1.05 y) x = 1 share of stock y = 28.57 of risk free bonds The value of the option is the value of the replicating portfolio: (1 $45) + (28.57) = $16.43

79.

Solution: The payoff from the call option is $0 if the stock price rises and $0 if the stock price falls. This option will never payoff, so it has a value of $0.

80.

Solution: The payoff from the put option is $0 if the stock price rises and $7 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($31 x) + (1.00 y) $7 = ($18 x) + (1.00 y) x = 0.54 shares of stock y = $16.69 of risk-free bonds The value of the option is the value of the replicating portfolio:

60 (-0.54 $22) + ($16.69) = $4.85

81.

Solution: The payoff from the put option is $0 if the stock price rises and $11 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($50 x) + (1.04 y) $11 = ($29 x) + (1.04 y) x = 0.52 shares of stock y = $25.18 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.52 $44) + ($28.18) = $2.14

82.

Solution: The payoff from the put option is $0 if the stock price rises and $9 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($23.50 x) + (1.03 y) $9 = ($9 x) + (1.03 y) x = 0.62 shares of stock y = $14.16 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.62 $16) + ($14.16) = $4.23

61

83.

Solution: The payoff from the put option is $0 if the stock price rises and $25 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($32 x) + (1.02 y) $25 = ($5 x) + (1.02 y) x = 0.93 shares of stock y = $29.05 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.93 $29) + ($29.05) = $2.20

84.

Solution: The payoff from the put option is $0 if the stock price rises and $3 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($30 x) + (1.00 y) $3 = ($12 x) + (1.00 y) x = 0.167 shares of stock y = $5 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.167 $18) + ($5) = $2

62 85. Solution: The payoff from the put option is $0 if the stock price rises and $5 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($10 x) + (1.01 y) $5 = ($0 x) + (1.01 y) x = 0.5 shares of stock y = $4.95 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.5 $2.6) + ($4.95) = $3.65

86.

Solution: First, we can calculate the value of the put option with the binomial model. The payoff from the put option is $0 if the stock price rises and $8 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($30 x) + (1.00 y) $8 = ($12 x) + (1.00 y) x = 0.44 shares of stock y = $13.33 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.44 $18) + ($13.33) = $5.33

63 The payoff from exercising the put option now is the option strike price minus the current stock price: $20 $18 = $2

87.

Solution: The payoff from the put option is $45 if the stock price rises and $48 if the stock price falls. When the put option pays off in either state, the value of the option is the PV of the strike price minus the current stock price. ($50 / 1.00) $4 = $46

88.

Solution: The payoff from the put option is $0 if the stock price rises and $0 if the stock price falls. Either way the put option has no payoff. The value of this put option is $0.

89.

Solution: To calculate the value of this portfolio, we can use the binomial pricing model to calculate that value of the call and the put. Then we can add the values together. The payoff from the call option is $5 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $5 = ($30 x) + (1.00 y) $0 = ($18 x) + (1.00 y) x = 0.417 shares of stock y = $7.5 of risk-free bonds

64 The value of the option is the value of the replicating portfolio: (0.417 $21) + (-7.5) = $1.25 The payoff from the put option is $0 if the stock price rises and $7 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($30 x) + (1.00 y) $7 = ($18 x) + (1.00 y) x = -0.583 shares of stock y = $17.5 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.583 $21) + ($17.5) = $5.25 The total value of the straddle is $1.25 + $5.25 = $6.50

90.

Solution: To calculate the value of this portfolio, we can use the binomial pricing model to calculate that value of the call and the put. Then we can add the values together. The payoff from the call option is $5 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $35 = ($50 x) + (1.08 y) $0 = ($2 x) + (1.08 y) x = 0.729 shares of stock y = $1.35 of risk-free bonds

65 The value of the option is the value of the replicating portfolio: (0.729 $16) + (1.35) = $10.32 The payoff from the put option is $0 if the stock price rises and $13 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($50 x) + (1.08 y) $13 = ($2 x) + (1.08 y) x = 0.271 shares of stock y = $12.54 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.271 $16) + ($12.54) = $8.20 The total value of the straddle is $10.32 + $8.20 = $18.52

91.

Solution: First we can price the LowVol call option. The payoff from the LowVol call option is $3 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $3 = ($18 x) + (1.00 y) $0 = ($14 x) + (1.00 y) x = 0.75 shares of stock y = $9.72 of risk free bonds The value of the option is the value of the replicating portfolio: (0.75 $16) + (-9.72) = $2.28

66 Next we can price the HighVol call option. The payoff from the HighVol call option is $7 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $7 = ($22 x) + (1.00 y) $0 = ($0 x) + (1.00 y) x = 0.32 shares of stock y = $0 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.32 $16) + ($0) = $5.09 The HighVol call option is worth more.

92.

Solution: The payoff from the call option is $4 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $4 = ($24 x) + (1.00 y) $0 = ($18 x) + (1.00 y) x = 0.67 shares of stock y = $12 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.67 $20) + (12) = $1.33

67 The payoff from the put option is $0 if the stock price rises and $2 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($24 x) + (1.00 y) $2 = ($18 x) + (1.00 y) x = -0.333 shares of stock y = $8 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.333 x $20) + ($8) = $1.33 The call and the put options are worth the same. Note that this is a special case where interest rates are zero. With a positive interest rate, the call will be worth more than the put.