Investments, by Bodie, Kane, and Marcus, 8th Edition

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MAIN MENU -- Chapter 21
SOLUTION
Problem 28

Copyright © 2009 McGraw-Hill/Irwin

Edition
 OUTPUTS FORMULA FOR OUTPUT IN COLUMN E
Standard deviation (annual) 0.3213 d1 0.0089 (LN(B5/B6)+(B4-B7+.5*B2^2)*B3)/(B2*SQRT(B3))
Maturity (in years) 0.5 d2 -0.2183 E2-B2*SQRT(B3)
Risk-free rate (annual) 0.05 N(d1) 0.5035 NORMSDIST(E2)
Stock Price 100 N(d2) 0.4136 NORMSDIST(E3)
Exercise price 105 B/S call value 8.00 B5*EXP(-B7*B3)*E4 - B6*EXP(-B4*B3)*E5
Dividend yield (annual) 0 B/S put value 10.41 B6*EXP(-B4*B3)*(1-E5) - B5*EXP(-B7*B3)*(1-E4)

28. Consider a 6-month expiration European call option with an exercise price of $105. The
underlying stock sells for $100 a share and pays no dividends. The risk-free rate is 5%. What is
the implied volatility of the option if the option currently sells for $8? Use Spreadsheet 21.1
(copied above) to answer this question. Return to Main Menu

Go to the Tools menu of the spreadsheet and select "Goal Seek." The dialogue box will ask you
for three pieces of information. In that dialogue box, you should set cell E6 to value 8 by
changing cell B2. In other words, you ask the spreadsheet to find the value of standard deviation
(which appears in cell B2) that forces the value of the option (in cell E6) equal to $8. Then, click
"OK" and you should find that the call is now worth $8, and the entry for standard deviation has
been changed to a level consistent with this value. This is the call’s implied standard deviation at
a price of $8.

a. What is the implied volatility of the option if the option currently sells for $8? Answer: 0.3213

b. What happens to implied volatility if the option is selling at $9? Why has implied volatility
increased? Answer: Implied volatility has increased because the value of an option increases
with greater volatility.

c. What happens to implied volatility if the option price is unchanged at $8, but option maturity is
lower, say only 4 months? Why? Answer: Implied volatility increases to 0.4087 when maturity
decreases to four months. The shorter maturity decreases the value of the option; therefore, in
order for the option price to remain unchanged at $8, implied volatility must increase.

d. What happens to implied volatility if the option price is unchanged at $8, but the exercise price
is lower, say only $100? Why? Answer: Implied volatility decreases to 0.2406 when exercise
price decreases to $100. The decrease in exercise price increases the value of the call, so that,
in order to the option price to remain at $8, implied volatility decreases.

e. What happens to implied volatility if the option price is unchanged at $8, but the stock is lower,
say only $98? Why? Answer: The decrease in stock price decreases the value of the call. In
order for the option price to remain at $8, implied volatility increases.

Copyright © 2009 McGraw-Hill/Irwin