Finance - Ch. 20 Financial Options

Option seller (writer)

-Sells (or writes) the option and has a SHORT position in the contract -Because the long side has the option to exercise, the short side has an obligation to fulfill the contract if it is exercised

stock options contracts are always written on how many shares of stock?

100 shares

Which of the following positions benefit if the stock price​ increases? A. Long position in a call. B. Long position in a put. C. Short position in a call. D. Short position in a put.

A and D

Which of the following statements is​ FALSE? A. The price at which the holder buys or sells the share of stock when the option is exercised is called the strike price or exercise price. B. When a holder of an option enforces the agreement and buys or sells a share of stock at the agreed−upon ​price, he is exercising the option. C. There are two kinds of options. European options allow their holders to exercise the option on any date up to and including a final date called the expiration date. Your answer is correct. D. Because an option is a contract between two​ parties, for every owner of a financial option there is also an option​ writer, the person who takes the other side of the contract.

C. There are two kinds of options. European options allow their holders to exercise the option on any date up to and including a final date called the expiration date. Your answer is correct.

Using options to reduce risk is​ called: A. speculation. B. a naked position. C. hedging. D. a covered position.

C. hedging.

As the seller of an​ option, you are guaranteed to receive​ the: A. exercise price. B. strike price. C. option premium. D. risk premium.

C. option premium.

Which of the following will NOT increase the value of a put​ option? A. An increase in the exercise price B. A decrease in the stock price C. A decrease in the​ stock's volatility D. An increase in the time to maturity

C. A decrease in the​ stock's volatility

Which of the following statements is​ FALSE? A. The intrinsic value of an option is the value it would have if it expired immediately. B. Put options increase in value as the stock price falls. C. A put option cannot be worth more than its strike price. D. A European option cannot be worth less than its American counterpart.

D. A European option cannot be worth less than its American counterpart.

option buyer (holder)

Holds the right to exercise the option and has a LONG position in the contract

option writer

The seller of an option contract

You happen to be checking the newspaper and notice an arbitrage opportunity. The current stock price of Intrawest is $15per share and the​ one-year risk-free interest rate is 7%. A​ one-year put on Intrawest with a strike price of $11 sells for $5.06​,while the identical call sells for $10.09. Intrawest​ doesn't pay any dividends. Explain what you must do to exploit this arbitrage opportunity.

The strategy would be to sell the call​ option, buy the put and the​ stock, and borrow $10.28. The net benefit is $0.31.

open interest

The total number of outstanding contracts of a particular option that have been written

Why do people write options?

When you. sell an option, you get paid for it - options always have positive prices

Financial Option

a contract that gives its owner the right (but not the obligation) to purchase or sell an asset at a fixed price at some future date

Deep in/out of the money

describes options where the strike price and the stock price are very far apart

When the holder of an option enforces the agreement and buys or sells a share of stock at the agreed-upon price, he is

exercising the option

stock option

gives the holder the option to buy or sell a share of stock on or before a given date for a given price

call option

gives the owner the right to BUY the asset

put option

gives the owner the right to SELL the asset

out-of-the-money

if the payoff from exercising an option immediately is negative

in-the-money

if the payoff from exercising an option immediately is positive

strike price (exercise price)

the price at which the holder buys or sells the share. of stock when the option is exercised

option premium

the price you pay to buy an option

at-the-money

when the exercise price of an option is equal to the current stock price, the option is at-the-money

What is the difference between an European option and an American​ option? Are European options available exclusively in Europe and American options available exclusively in the United​ States? A. European options can be exercised only on the exercise date and are exclusively available in​ Europe, while American options can be exercised on any date prior to the exercise date and are exclusively available in America. B. European options can be exercised only on the exercise​ date, while American options can be exercised on any date prior to the exercise date. Both types of options are traded in Europe and in America. C. The only difference between the European option and the American option is that the European options are only available in​ Europe, and the American options are exclusively available in America. D. American options can be exercised only on the exercise​ date, while European options can be exercised on any date prior to the exercise date. Both types of options are traded in Europe and in America.

B. European options can be exercised only on the exercise​ date, while American options can be exercised on any date prior to the exercise date. Both types of options are traded in Europe and in America.

Explain why an American call option on a​ non-dividend-paying stock always has the same price as its European counterpart.

Because the option to exercise early is worthless​, the American option provides no more benefits than its European counterpart. ​

Explain the difference between a long position in a put and a short position in a call. A. When a party has a long position in a​ put, it has the obligation to sell the underlying asset at the strike​ price; when it has a short position in a​ call, it has the obligation to buy the underlying asset at the strike price if exercised. B. When a party has a long position in a​ put, it has the obligation to buy the underlying asset at the strike​ price; when it has a short position in a​ call, it has the right to sell the underlying asset at the strike price if exercised. C. When a party has a long position in a​ put, it has the right to sell the underlying asset at the strike​ price; when it has a short position in a​ call, it has the right to buy the underlying asset at the strike price if exercised. D. When a party has a long position in a​ put, it has the right to sell the underlying asset at the strike​ price; when it has a short position in a​ call, it has the obligation to sell the underlying asset at the strike price if exercised.

D. When a party has a long position in a​ put, it has the right to sell the underlying asset at the strike​ price; when it has a short position in a​ call, it has the obligation to sell the underlying asset at the strike price if exercised.

An option strategy in which you hold a long position in both a put and a call option with the same strike price is​called: A. a butterfly spread. B. portfolio insurance. C. a strangle. D. a straddle.

D. a straddle.

A credit default swap is essentially​ a: A. call option on the​ firm's assets. B. put option on the​ firm's debt. C. call option on the​ firm's debt. D. put option on the​ firm's assets.

D. put option on the​ firm's assets.

Wesley Corp. stock is trading for ​$35 per share. Wesley has 25 million shares outstanding and a market​ debt-equity ratio of 0.62. ​Wesley's debt is​ zero-coupon debt with a​ 5-year maturity and a yield to maturity of 9%. a. Describe​ Wesley's equity as a call option. What is the maturity of the call​ option? What is the market value of the asset underlying this call​ option? What is the strike price of this call​ option? b. Describe​ Wesley's debt using a call option. c. Describe​ Wesley's debt using a put option.

a. The maturity is 5 years. Total assets is equal to equity plus debt.​ Therefore, Assets=$35 per share×25 million shares+0.62×($35 per share×25 million shares)=$1,417.50 million The market value of the asset underlying this call option is ​$1,417.50 million. The strike price is equal to the face value of the debt.​ Therefore, Face Value of Debt=0.62×($35 per share×25 million shares)×(1+0.09)5=$834.70 million The strike price of this call option is ​$834.70 million. b. Buy the​ firm's assets and short the equity call option with a strike price equal to $834.70 million. c. Long​ risk-free debt with a​ 5-yr maturity and $834.70 million face value and short a put option on​ Wesley's assets with a ​ 5-yr maturity and a strike of $834.70 million

Suppose Amazon stock is trading for $2020 per​ share, and Amazon pays no dividends. a. What is the maximum possible price of a call option on​ Amazon? b. What is the maximum possible price of a put option on Amazon with a strike price of $2080​? c. What is the minimum possible value of a call option on Amazon stock with a strike price of $2000​? d. What is the minimum possible value of an American put option on Amazon stock with a strike price of $2080​?

a. The maximum possible price of the call option on Amazon would be ​$2020 b. The maximum possible price of a put option on Amazon would be ​$2080 c. The minimum possible value of the call option on Amazon stock would be $20 ​d. The minimum possible value of the American put option on Amazon stock would be $60

American Option

can be exercised on or before its expiration

European option

can be exercised only at expiration