Explain which option (i.e. put or call) positions (i.e. long or short) offers the most risk....

Explain which option (i.e. put or call) positions (i.e. long or short) offers the most risk.

Explain how a firm’s equity can be compared to a call option. How does this help explain why managers may select riskier projects at the expense of bondholders?

Solutions

Expert Solution

Long call option and long put option have limited risk but short put option and short call option have unlimited risk because when we will be starting with call and put option there will be no upside capping risk and once the share starts to rise, it can go unlimited and the loss will be unlimited also. Hence, short put and short call are most risky.

Firm equity will be increasing and call option is always taken on the share price increased so when the firm's equity will be increasing the market capitalisation of this stock will be increasing and the share price of the company will also be increasing so it will be leading to increase in the call option and when it will be going down the value of the call option will also go down because there will be decreasing share price.

Manager will be selecting risky projects because they will want to increase the price of overall share and maximize profit so they will be trying to increase the market capitalisation and the profits of the company and value of the firm will be increasing against the expense of the bondholders because they will be taking higher risk so it will be also reacting positively for call option.

jeff jeffy answered 1 year ago

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