Question

In: Finance

I have bolded the answers I chose. I just need someone to check my work and...

I have bolded the answers I chose. I just need someone to check my work and if I'm wrong possibly explain why, please?

1. If a stock pays a dividend, the owner of a call option will see the value of their option decrease by the amount of that dividend payment.

a. true

b. false

2. DEF stock currently trades for $40. Both American calls and puts are available on the stock. All else being constant, which of the following will occur if the stock price falls to $35?

a. Both the call and put premium will increase.

b. The call premium will increase while the put premium will decrease.

c. Both the call and put premium will decrease.

d. None of the above.

3. PQU stock has two series of European call options. Both series expire in six months, but one series has a strike price of $50, while the other series has an exercise price of $60. If the market is in equilibrium, it must case that the $50 series has a higher premium than the $60 series on any given day prior to expiration.

a. true

b. false

4. A 9-month American call on Smith stock with an exercise price of $20 sells for $1.25. A 9-month European call on Smith stock carries a strike price and premium of $22 and $1.1, respectively. If the American call isn't exercised early, which of the following will occur when the options expire?

a. The American call will have a higher premium than the European call.

b. The American call will have a lower premium than the European call.

c. The premiums for both options will be the same.

d. Cannot be determined.

Solutions

Expert Solution

1] False

If a stock pays a dividend, the price of the stock will decrease by the amount of dividend payment. However, the value of the option will decrease only by a fraction of the dividend payment. This is because the price of an options as per the Black-Scholes formula inputs dividend as a percentage of the share price. Since dividend yield is usually a small percentage of the price, the decrease in value of the call option will also be a small percentage of the dividend amount

2]

d - none of the above

The value of a call option will increase with a rise in underlying stock price. The value of a call option will decrease with a fall in underlying stock price.

The value of a put option will decrease with a rise in underlying stock price. The value of a put option will increase with a fall in underlying stock price.

In this case, if the stock price falls from $40 to $35, the put premium will increase and the call premium will decrease

3] True

The value of call options that are in-the-money (lower strike price) will be higher than the value of options that are out-of-money (higher strike price). This is because the call options with lower strike price will have more intrinsic value

4]  

b - The American call will have a lower premium than the European call.

This is because the American call has a lower strike price than the European call. Hence, at expiry, the intrinsic value of the American call is lower than the European call


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