Question

For every question, please write down each main step before you obtain the final answer. Correct final answer with incorrect related work (calculation) or without any work may receive 0 point. On the contrary, incorrect final answer with correct related work (calculation) will receive partial credits.

Question 3 – Call Option [4 points]: Suppose you own a call option that permits you to purchase 100 shares of the stock of Silicon Graphics for $15 per share any time in the next 3 months. Silicon Graphics has a current market price of $12 per share. Ignore taxes and transaction costs.

a) Should you exercise the option and purchase the stock if its price increases to $17? What would be your gain (loss) if you exercised the option and then immediately sold the stock?

b) Should you exercise the option and purchase the stock if its price increases to $14? What would be your gain (loss) if you exercised the option and then immediately sold the stock?

Answer 1

Call option profit function:
( MAX ( underlying price – strike price , 0 ) – initial option price)

Strike price = $15

Current underlying price = $12
Call price = $0 (assumed, since it's not given)

a) Yes, the call option should be exercised. If the stock price increases to $17, profit would be $200.
Since using the call option you'd buy the stock at $15 and immediately sell it in the market at $17, igonring taxes and transaction costs, you'd earn $2 per stock and since we have 100 stocks, our total profit would be $200.

b)No, the call option should not be exercised. If the satock price increases to $14, profit using the call option would be $0.
Since using the call option you'd we could buy the stock at $15, but the price in the market is $14 currently. So, it would make more sense to buy the stock directly from the market and not exercise the call option. If we excercise the call option and then immediately sell the stock, we'd lose $1 per stock or $100 for 100 stocks.