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Chapter 20 - Understanding Options
Chapter 20 - Understanding Options
Chapter 20 - Understanding Options
Chapter 20
Understanding Options
Multiple Choice Questions
20-1
4. An option that can be exercised any time before expiration date is called:
A. an European option
B. an American option
C. a call option
D. a put option
20-2
8. In June 2007, an investor buys a call option on Amgen stock with an exercise of price of
$65 and expiring in January 2009. If the stock price in June 2003 is $60, then this option is:
I) in-the-money
II) out-of-the-money
III) a LEAPS
A. I only
B. II only
C. III only
D. II and III only
9. The Position diagram for a put with the same exercise price and premium as the call on the
same underlying asset with the same maturity is (like):
A. the inverse of the call diagram along the put price
B. unrelated to the call diagram no matter what the exercise price
C. the mirror image of the call diagram around the exercise price
D. exactly the same as the call diagram for the given exercise price
10. In June 2007, an investor buys a put option on Genentech stock with an exercise of price
of $75 and expiring in January 2009. If the stock price in June 2007 is $80, then this option is:
I) in-the-money
II) out-of-the-money
III) a LEAPS
A. I only
B. II only
C. III only
D. I and III only
20-3
12. The buyer of a call option has the right to exercise, but the writer of the call option has:
A. The choice to offset with a put option
B. The obligation to deliver the shares at exercise price
C. The choice to deliver shares or take a cash payoff
D. The choice of exercising the call or not
13. Suppose an investor sells (writes) a put option. What will happen if the stock price on the
exercise date exceeds the exercise price?
A. The seller will need to deliver stock to the owner of the option
B. The seller will be obliged to buy stock from the owner of the option
C. The owner will not exercise his option
D. None of the above
20-4
20-5
21. Suppose an investor buys one share of stock and a put option on the stock. What will be
the value of her investment on the final exercise date if the stock price is below the exercise
price? (Ignore transaction costs)
A. The value of two shares of stock
B. The value of one share of stock plus the exercise price
C. The exercise price
D. The value of one share of stock minus the exercise price
20-6
22. Which of the following investors would be happy to see the stock price rise sharply?
I) Investor who owns the stock and a put option
II) Investor who has sold a put option and bought a call option
III) Investor who owns the stock and has sold a call option
IV) Investor who has sold a call option
A. I and II only
B. III and IV only
C. III only
D. IV only
23. Buying a call option, investing the present value of the exercise price in T-bills, and short
selling the underlying share is the same as:
A. Buying a call and a put
B. Buying a put and a share
C. Buying a put
D. Selling a call
24. Buying the stock and the put option on the stock provides the same payoff as:
A. investing the present value of the exercise price in T-bills and buying the call option
B. on the stock
C. short selling the stock and buying a call option on the stock
D. writing (selling) a put option and buying a call option on the stock
E. none of above
25. Suppose you buy a call and lend the present value of its exercise price. You could match
the payoffs of this strategy by:
A. Buying the underlying stock and selling a call
B. Selling a put and lending the present value of the exercise price
C. Buying the underlying stock and buying a put
D. Buying the underlying stock and selling a put
20-7
26. Suppose an investor buys one share of stock and a put option on the stock and
simultaneously sells a call option on the stock with the same exercise price. What will be the
value of his investment on the final exercise date?
A. Above the exercise price if the stock price rises and below the exercise price if it falls
B. Equal to the exercise price regardless of the stock price
C. Equal to zero regardless of the stock price
D. Below the exercise price if the stock price rises and above if it falls
28. For European options, the value of a call minus the value of a put is equal to:
A. The present value of the exercise price minus the value of a share
B. The present value of the exercise price plus the value of a share
C. The value of a share plus the present value of the exercise price
D. The value of a share minus the present value of the exercise price
29. If the stock makes a dividend payment before the expiration date then the put-call parity
is:
A. Value of call = value of put + share price - present value (PV) of dividend -PV of exercise
price
B. Value of call = value of put - share price + PV of dividend - PV of exercise price
C. Value of call = value of put + share price + PV of dividend + PV of exercise price
D. Value of call = value of put + share price + PV of dividend - PV of exercise price
20-8
30. If the underlying stock pays a dividend before the expiration of the options that will have
the following effect on the price of the options:
I) increase the value of the call option
II) increase the value of the put option
III) decrease the value of the call option
IV) decrease the value of the put option
A. I and II only
B. III and IV only
C. I and IV only
D. II and III only
31. For European options, the value of a call plus the present value of the exercise price is
equal to:
A. The value of a put minus the value of a share
B. The value of a share minus the value of a call
C. The value of a put plus the value of a share
D. The value of a share minus the value of a put
33. Given the following data: Expiration = 6 months; Stock price = $80; exercise price = $75;
call option price = $12; risk-free rate = 5% per year. Calculate the price of an equivalent put
option using put-call parity:
A. $3.07
B. $5.19
C. $11.43
D. none of the above
20-9
34. The higher the underlying stock price: (everything else remaining the same)
A. higher the put price
B. lower the put price
C. has no effect on put price
D. none of the above
35. The higher the underlying stock price: (everything else remaining the same)
A. higher the call price
B. lower the call price
C. has no effect on call price
D. none of the above
38. Which of the following features increase(s) the value of a call option?
A. A high interest rate
B. A long time to maturity
C. A higher volatility of the underlying stock price
D. All of the above
20-10
39. A call option has an exercise price of $150. At the final exercise date, the stock price
could be either $100 or $200. Which investment would combine to give the same payoff as
the stock?
A. Lend PV of $100 and buy two calls
B. Lend PV of $100 and sell two calls
C. Borrow $100 and buy two calls
D. Borrow $100 and sell two calls
41. If the stock price follows a random walk successive price changes are statistically
independent. If 2 is the variance of daily price change, and there are t days until expiration,
the variance of the cumulative price changes is:
A. 2
B. (2) * (t)
C. (2)/t
D. none of the above
42. The value of an option (both call and put) is positively related to:
I) volatility of the underlying stock price
II) time to expiration
III) risk-free rate
A. I and II only
B. II and III only
C. I and III only
D. III only
20-11
20-12
47. The value of a call option, beyond the stock price less the exercise price, is most likely to
be realized when the option is:
A. out of the money.
B. in the money.
C. at the money.
D. cannot be determined.
48. If a put and call cost the same, how can an investor offset the cost of a buying a call?
A. Borrowing money
B. Sell a put
C. Sell a stock
D. Wait for the stock price to rise
49. A call options gives its owner the right to buy stock at a fixed strike price during a
specified period of time.
True False
50. An European option gives its owner the right to exercise the option at any time before
expiration.
True False
20-13
51. If you write a put option, you acquire the right to buy stock at a fixed strike price.
True False
52. The writer of a put option loses if the stock price declines.
True False
53. Position diagrams and profit diagrams are one and the same.
True False
54. An investor can get downside protection by buying a stock and a put option.
True False
55. Buying a stock and a put option, and depositing the present value of the exercise price in a
bank account and buying a call provide the same payoff.
True False
56. Options can have a value even when the stock is worthless.
True False
57. For an European option: Value of call + PV(exercise price) = Value of put + share price.
True False
58. An increase in the stock price results in an increase in the call option price.
True False
20-14
59. An increase in the exercise price results in an equal increase in the call option price.
True False
60. The value of a call option increases with higher volatility of the stock prices.
True False
62. Options written on volatile assets are worth more than options written on safer assets.
True False
63. All things being equal, the closer an option gets to expiration, the lower the option price.
True False
64. Buying an in the money option will almost always produce a profit.
True False
20-15
66. Explain the difference between a European option and an American option.
20-16
70. Explain the main differences between the position diagrams and the profit diagrams.
73. Discuss the factors that determine the value of a call option.
20-17
74. Briefly explain how an option holder gains from the volatility of the underlying stock
price.
75. Briefly explain the relationship between risk and option values.
76. Why would an option holder almost never exercise an option early?
20-18
Type: Medium
Type: Medium
20-19
Type: Easy
4. An option that can be exercised any time before expiration date is called:
A. an European option
B. an American option
C. a call option
D. a put option
Type: Easy
Type: Easy
20-20
Type: Medium
Type: Medium
8. In June 2007, an investor buys a call option on Amgen stock with an exercise of price of
$65 and expiring in January 2009. If the stock price in June 2003 is $60, then this option is:
I) in-the-money
II) out-of-the-money
III) a LEAPS
A. I only
B. II only
C. III only
D. II and III only
Type: Easy
9. The Position diagram for a put with the same exercise price and premium as the call on the
same underlying asset with the same maturity is (like):
A. the inverse of the call diagram along the put price
B. unrelated to the call diagram no matter what the exercise price
C. the mirror image of the call diagram around the exercise price
D. exactly the same as the call diagram for the given exercise price
Type: Difficult
20-21
10. In June 2007, an investor buys a put option on Genentech stock with an exercise of price
of $75 and expiring in January 2009. If the stock price in June 2007 is $80, then this option is:
I) in-the-money
II) out-of-the-money
III) a LEAPS
A. I only
B. II only
C. III only
D. I and III only
Type: Easy
Type: Medium
12. The buyer of a call option has the right to exercise, but the writer of the call option has:
A. The choice to offset with a put option
B. The obligation to deliver the shares at exercise price
C. The choice to deliver shares or take a cash payoff
D. The choice of exercising the call or not
Type: Difficult
13. Suppose an investor sells (writes) a put option. What will happen if the stock price on the
exercise date exceeds the exercise price?
A. The seller will need to deliver stock to the owner of the option
B. The seller will be obliged to buy stock from the owner of the option
C. The owner will not exercise his option
D. None of the above
Type: Medium
20-22
Type: Medium
Type: Medium
Type: Medium
20-23
Type: Medium
Type: Medium
20-24
Type: Medium
Type: Medium
20-25
21. Suppose an investor buys one share of stock and a put option on the stock. What will be
the value of her investment on the final exercise date if the stock price is below the exercise
price? (Ignore transaction costs)
A. The value of two shares of stock
B. The value of one share of stock plus the exercise price
C. The exercise price
D. The value of one share of stock minus the exercise price
Type: Difficult
22. Which of the following investors would be happy to see the stock price rise sharply?
I) Investor who owns the stock and a put option
II) Investor who has sold a put option and bought a call option
III) Investor who owns the stock and has sold a call option
IV) Investor who has sold a call option
A. I and II only
B. III and IV only
C. III only
D. IV only
Type: Difficult
23. Buying a call option, investing the present value of the exercise price in T-bills, and short
selling the underlying share is the same as:
A. Buying a call and a put
B. Buying a put and a share
C. Buying a put
D. Selling a call
Type: Difficult
20-26
24. Buying the stock and the put option on the stock provides the same payoff as:
A. investing the present value of the exercise price in T-bills and buying the call option
B. on the stock
C. short selling the stock and buying a call option on the stock
D. writing (selling) a put option and buying a call option on the stock
E. none of above
Type: Difficult
25. Suppose you buy a call and lend the present value of its exercise price. You could match
the payoffs of this strategy by:
A. Buying the underlying stock and selling a call
B. Selling a put and lending the present value of the exercise price
C. Buying the underlying stock and buying a put
D. Buying the underlying stock and selling a put
Type: Difficult
26. Suppose an investor buys one share of stock and a put option on the stock and
simultaneously sells a call option on the stock with the same exercise price. What will be the
value of his investment on the final exercise date?
A. Above the exercise price if the stock price rises and below the exercise price if it falls
B. Equal to the exercise price regardless of the stock price
C. Equal to zero regardless of the stock price
D. Below the exercise price if the stock price rises and above if it falls
Type: Difficult
20-27
Type: Difficult
28. For European options, the value of a call minus the value of a put is equal to:
A. The present value of the exercise price minus the value of a share
B. The present value of the exercise price plus the value of a share
C. The value of a share plus the present value of the exercise price
D. The value of a share minus the present value of the exercise price
Type: Difficult
29. If the stock makes a dividend payment before the expiration date then the put-call parity
is:
A. Value of call = value of put + share price - present value (PV) of dividend -PV of exercise
price
B. Value of call = value of put - share price + PV of dividend - PV of exercise price
C. Value of call = value of put + share price + PV of dividend + PV of exercise price
D. Value of call = value of put + share price + PV of dividend - PV of exercise price
Type: Difficult
20-28
30. If the underlying stock pays a dividend before the expiration of the options that will have
the following effect on the price of the options:
I) increase the value of the call option
II) increase the value of the put option
III) decrease the value of the call option
IV) decrease the value of the put option
A. I and II only
B. III and IV only
C. I and IV only
D. II and III only
Type: Difficult
31. For European options, the value of a call plus the present value of the exercise price is
equal to:
A. The value of a put minus the value of a share
B. The value of a share minus the value of a call
C. The value of a put plus the value of a share
D. The value of a share minus the value of a put
Type: Difficult
Type: Difficult
20-29
33. Given the following data: Expiration = 6 months; Stock price = $80; exercise price = $75;
call option price = $12; risk-free rate = 5% per year. Calculate the price of an equivalent put
option using put-call parity:
A. $3.07
B. $5.19
C. $11.43
D. none of the above
value of put = value of call - share price + PV of exercise price
= 12 - 80 + 75/(1.05^0.5) = 12 - 80 + 73.19 = $5.19
Type: Difficult
34. The higher the underlying stock price: (everything else remaining the same)
A. higher the put price
B. lower the put price
C. has no effect on put price
D. none of the above
Type: Medium
35. The higher the underlying stock price: (everything else remaining the same)
A. higher the call price
B. lower the call price
C. has no effect on call price
D. none of the above
Type: Medium
Type: Difficult
20-30
Type: Difficult
38. Which of the following features increase(s) the value of a call option?
A. A high interest rate
B. A long time to maturity
C. A higher volatility of the underlying stock price
D. All of the above
Type: Medium
39. A call option has an exercise price of $150. At the final exercise date, the stock price
could be either $100 or $200. Which investment would combine to give the same payoff as
the stock?
A. Lend PV of $100 and buy two calls
B. Lend PV of $100 and sell two calls
C. Borrow $100 and buy two calls
D. Borrow $100 and sell two calls
Value of two calls: 2(200 - 150) = 100 or value of two calls = 2(100 - 150) = 0 (not
exercised); payoff = 100 + 100 = 200 or payoff = 0 + 100 = 100
Type: Difficult
Type: Difficult
20-31
41. If the stock price follows a random walk successive price changes are statistically
independent. If 2 is the variance of daily price change, and there are t days until expiration,
the variance of the cumulative price changes is:
A. 2
B. (2) * (t)
C. (2)/t
D. none of the above
Type: Difficult
42. The value of an option (both call and put) is positively related to:
I) volatility of the underlying stock price
II) time to expiration
III) risk-free rate
A. I and II only
B. II and III only
C. I and III only
D. III only
Type: Medium
Type: Medium
20-32
Type: Medium
Type: Medium
Type: Medium
20-33
47. The value of a call option, beyond the stock price less the exercise price, is most likely to
be realized when the option is:
A. out of the money.
B. in the money.
C. at the money.
D. cannot be determined.
Type: Difficult
48. If a put and call cost the same, how can an investor offset the cost of a buying a call?
A. Borrowing money
B. Sell a put
C. Sell a stock
D. Wait for the stock price to rise
Type: Difficult
49. A call options gives its owner the right to buy stock at a fixed strike price during a
specified period of time.
TRUE
Type: Easy
50. An European option gives its owner the right to exercise the option at any time before
expiration.
FALSE
Type: Medium
20-34
51. If you write a put option, you acquire the right to buy stock at a fixed strike price.
FALSE
Type: Medium
52. The writer of a put option loses if the stock price declines.
TRUE
Type: Medium
53. Position diagrams and profit diagrams are one and the same.
FALSE
Type: Medium
54. An investor can get downside protection by buying a stock and a put option.
TRUE
Type: Difficult
55. Buying a stock and a put option, and depositing the present value of the exercise price in a
bank account and buying a call provide the same payoff.
TRUE
Type: Difficult
56. Options can have a value even when the stock is worthless.
FALSE
Type: Medium
20-35
57. For an European option: Value of call + PV(exercise price) = Value of put + share price.
TRUE
Type: Medium
58. An increase in the stock price results in an increase in the call option price.
TRUE
Type: Medium
59. An increase in the exercise price results in an equal increase in the call option price.
FALSE
Type: Medium
60. The value of a call option increases with higher volatility of the stock prices.
TRUE
Type: Medium
Type: Medium
62. Options written on volatile assets are worth more than options written on safer assets.
TRUE
Type: Medium
20-36
63. All things being equal, the closer an option gets to expiration, the lower the option price.
TRUE
Type: Medium
64. Buying an in the money option will almost always produce a profit.
FALSE
Type: Medium
Type: Easy
66. Explain the difference between a European option and an American option.
A European option may be exercised only on the expiration date. An American option may be
exercised anytime up to the expiration date.
Type: Easy
Type: Easy
20-37
Type: Easy
Type: Medium
70. Explain the main differences between the position diagrams and the profit diagrams.
Position diagrams show payoffs at option exercise. Share price is plotted on the x-axis and
option value on the y-axis. They are useful in analyzing the position of option buyers and
sellers at exercise. They do not consider the cost of options. Profit diagrams on the other hand
consider the cost of options also. Profit diagrams provide a clearer picture of profits and
losses resulting from trading in options. They are also helpful in analyzing trading strategies.
Type: Difficult
Type: Easy
20-38
Type: Medium
73. Discuss the factors that determine the value of a call option.
The value of a call option is determined by five factors. They are: stock price, exercise price,
risk free interest rate, volatility of the stock price, and time to expiration.
Type: Medium
74. Briefly explain how an option holder gains from the volatility of the underlying stock
price.
An option holder gains from the volatility of the underlying stock price because of the
asymmetric payoffs of options. For example, if the stock price falls below the exercise price
the call option will be worthless, regardless of whether the drop in the price is only a few
cents or many dollars. On the other hand, for every dollar stock price increase above the
exercise price will also increase the option price by almost the same amount. Hence, the
option holder gains from the increased volatility on the upside, but does not lose on the down
side.
Type: Difficult
75. Briefly explain the relationship between risk and option values.
Options on volatile (risky) assets are more valuable than options on safer assets. This is in
contrast to most financial settings in which risk is a bad thing and investors have to be paid to
bear it. The value of an option increases with the volatility of the underlying stock price.
Type: Medium
20-39
76. Why would an option holder almost never exercise an option early?
Before expiration, the option value is almost always higher than the value of exercising the
option. In the case of a call, the stock price less the exercise price is almost always less than
the option price due to volatility and time. As such, the better choice is to sell the option and
realize a higher profit.
Type: Difficult
20-40