Chapter 20

Understanding Options

Multiple Choice Questions

1. Firms regularly use the following to reduce risk:

I) currency options; II) interest-rate options; III) commodity options

A. I only
B. II
only
C. III
only
D. I, II, and
III

2. The following are examples of "disguised options":

I) acquiring growth opportunities;

II) ability of the firm to terminate a project when it is no longer profitable;
III) covenants within corporate securities that provide flexibility to change the terms of the securities

A. I only
B. II
only
C. I and III only
D. I, II, and
III

20-1
3. An investor, in practice, can buy:

I) an option on a single share of stock;

II) options that are sold in blocks of 100 options per block;
III) a minimum order of 100 options on a share of stock

A. I only
B. II and III
only
C. II
only
D. III
only

4. An option that can be exercised any time before its expiration date is called:

A. a European option.
B. an American option.
C. a call option.
D. a put option.

5. The two principal options exchanges in the U.S. are the:

I) International Securities Exchange;

II) New York Stock Exchange;
III) NASDAQ;
IV) Chicago Board of Options Exchange

A. II and III
only
B. I and II only
C. I and IV only
D. III and IV
only

6. The owner of a regular exchange-listed call-option on a stock:

A. has the right to buy 100 shares of the underlying stock at the exercise price.
B. has the right to sell 100 shares of the underlying stock at the exercise price.
C. has the obligation to buy 100 shares of the underlying stock at the exercise price.
D. has the obligation to sell 100 shares of the underlying stock at the exercise price.

20-2
7. The owner of a regular exchange-listed put-option on a stock:

A. has the right to buy 100 shares of the underlying stock at the exercise price.
B. has the right to sell 100 shares of the underlying stock at the exercise price.
C. has the obligation to buy 100 shares of the underlying stock at the exercise price.
D. has the obligation to sell 100 shares of the underlying stock at the exercise price.

8. In June 2017, an investor buys call options on Amgen stock with an exercise of price of $65 and expiring in
January 2019. If the stock price in June 2018 is $60, then these options are:

I) in-the-money; II) out-of-the-money; III) a LEAPS option

A. I only
B. II
only
C. III
only
D. II and III
only

9. From a geometric viewpoint, how is the position diagram for a put option related to the diagram of a call
option on the same stock having the same exercise price and maturity?

A. The inverse of the call diagram

B. Unrelated to the call diagram no matter what the exercise price
C. The mirror image of the call diagram, reflected around the exercise price
D. Exactly the same as the call diagram for the given exercise price

10. In June 2017, an investor buys a put option on Genentech stock with an exercise price of $75 and expiring
in January 2019. If the stock price in July 2017 is $80, then this option is:

I) in-the-money
II) out-of-the-money
III) a LEAPS option

A. I only
B. II
only
C. III
only
D. II and III
only

20-3
11. A put option gives the owner the right:

A. and the obligation to buy an asset at a given price.

B. and the obligation to sell an asset at a given price.
C. but not the obligation to buy an asset at a given price.
D. but not the obligation to sell an asset at a given price.

12. The buyer of a call option has the right to exercise the option, but the writer of the call option has the:

A. choice to offset with a put option upon exercise.

B. obligation to deliver the shares at the exercise price.
C. choice to deliver shares or take a cash payoff.
D. obligation to deliver a put option upon exercise.

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. The option will extend for nine more months.

14. The writer (seller) of a regular exchange-listed call-option on a stock:

A. has the right to buy 100 shares of the underlying stock at the exercise price.
B. has the right to sell 100 shares of the underlying stock at the exercise price.
C. has the obligation to buy 100 shares of the underlying stock at the exercise price.
D. has the obligation to sell 100 shares of the underlying stock at the exercise price.

15. The writer (seller) of a regular exchange-listed put-option on a stock:

A. has the right to buy 100 shares of the underlying stock at the exercise price.
B. has the right to sell 100 shares of the underlying stock at the exercise price.
C. has the obligation to buy 100 shares of the underlying stock at the exercise price.
D. has the obligation to sell 100 shares of the underlying stock at the exercise price.

20-4
16. The value of a put option at expiration equals the:

A. market price of the share minus the exercise price.

B. higher of the exercise price minus market price of the share and zero.
C. exercise price.
D. share price.

17. Figure 1 depicts the:

A. position diagram for the buyer of a call option.

B. profit diagram for the buyer of a call option.
C. position diagram for the buyer of a put option.
D. profit diagram for the buyer of a put option.

18. Figure 2 depicts the:

A. position diagram for the buyer of a call option.

B. profit diagram for the buyer of a call option.
C. position diagram for the buyer of a put option.
D. profit diagram for the buyer of a put option.

20-5
19. Figure 3 depicts the:

A. position diagram for the writer (seller) of a call option.

B. profit diagram for the writer (seller) of a call option.
C. position diagram for the writer (seller) of a put option.
D. profit diagram for the writer (seller) of a put option.

20. Figure 4 depicts the:

A. position diagram for the writer (seller) of a call option.

B. profit diagram for the writer (seller) of a call option.
C. position diagram for the writer (seller) of a put option.
D. profit diagram for the writer (seller) of a put option.

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) An investor who owns the stock and a put option;

II) An investor who has sold a put option and bought a call option;
III) An investor who owns the stock and has sold a call option;
IV) An 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 on the stock.
B. short-selling the stock and buying a call option on the stock.
C. writing (selling) a put option and buying a call option on the stock.
D. a T-bill.

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

27. Put-call parity can be used to show:

A. how valuable in-the-money put options can get.

B. how valuable in-the-money call options can get.
C. the precise relationship between put and call option prices given equal exercise prices and equal
expiration dates.
D. that the value of a call option is always twice that of a put given equal exercise prices and equal
expiration dates.

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 relation 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. Suppose the underlying stock pays a dividend before the expiration of options on that stock. This will:

I) increase the value of a call option;

II) increase the value of a put option;
III) decrease the value of a call option;
IV) decrease the value of a 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.

32. For European options, the value of a put is equal to:

A. the value of a call minus the value of a share plus the present value of the exercise price.
B. the value of a call plus the value of a share plus the present value of the exercise price.
C. the value of the share minus the value of a call plus the present value of the exercise price.
D. the value of the share minus the present value of the exercise price plus the value of a call.

33. Consider the following data for a European option: Expiration = 6 months; Stock price = $80; Exercise
price = $75; Call option price = $12; Risk-free rate = 5% per year. Using put-call parity, calculate the price
of a put option having the same exercise price and expiration date.

A. $3.07
B. $5.1
9
C. $11.4
3
D. $3.42

20-9
34. All else equal, as the underlying stock price increases:

A. the put price increases.

B. the put price decreases.
C. there is no effect on put price.
D. the put price can either increase, decrease, or remain the same.

35. All else equal, as the underlying stock price increases:

A. the call price decreases.

B. the call price increases.
C. there is no effect on call price.
D. the call price can either increase, decrease, or remain the same.

36. If the risk-free interest rate increases, then:

A. call option prices increase.

B. call option prices decrease.
C. call option prices remain the same.
D. call option prices can either increase, decrease, or remain the same.

37. If the volatility of the underlying asset decreases, then the:

A. value of the put option will increase, but the value of the call option will decrease.
B. value of the put option will decrease, but the value of the call option will increase.
C. value of both the put and call option will increase.
D. value of both the put and call option will decrease.

20-10
38. Which of the following features increase(s) the value of a call option?

I) A high interest rate;

II) A long time to maturity;
III) A higher volatility of the underlying stock price

A. I only
B. II
only
C. III
only
D. I, II, and
III

39. A call option has an exercise price of $150. At the option expiration 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

40. Relative to the underlying stock, a call option always has:

A. a higher beta and a higher standard deviation of return.

B. a lower beta and a higher standard deviation of return.
C. a higher beta and a lower standard deviation of return.
D. a lower beta and a lower standard deviation of return.

41. If the stock price follows a random walk, successive price changes are statistically independent. If σ 2 is the
variance of the daily price change, and there are t days until expiration, the variance of the cumulative price
change is:

A. σ2
B. (σ2) × (t)
C. (σ2)/t
D. (σ) × (t2)

20-11
42. The value of any option (both call and put options) is positively related to the:

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

43. The value of a call option is positively related to the following:

I) underlying stock price; II) risk-free rate; III) time to expiration; IV) volatility of the underlying stock
price

A. I only
B. II
only
C. III
only
D. I, II, III, and
IV

44. The value of a call option is negatively related to the:

I) exercise price; II) risk-free rate; III) time to expiration

A. I only
B. II
only
C. III
only
D. II and III
only

20-12
45. The value of a put option is positively related to the:

I) exercise price; II) time to expiration; III) volatility of the underlying stock price; IV) risk-free rate

A. I, II, and III

only
B. II, III, and IV
only
C. I, II, and IV
only
D. IV
only

46. The value of a put option is negatively related to the:

I) stock price; II) volatility of the underlying stock price; III) exercise price

A. I only
B. II
only
C. I and II only
D. III
only

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.

True / False Questions

48. A profit diagram implicitly neglects the time value of money.

True False

20-13
49. An American call option gives its owner the right to buy stock at a fixed strike price during a specified
period of time.

True False

50. A European option gives its owner the right to exercise the option at any time before expiration.

True False

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 on the purchase of stock by buying a put option.

True False

55. Buying a stock and a put option, and lending the present value of the exercise price provide the same
payoff as buying a call option.

True False

56. Call options can have a positive value at expiration even when the underlying stock is worthless.

True False

57. For a European option: Value of call + PV(exercise price) = value of put + share price.

True False

58. An increase in the underlying stock price results in an increase in a call option's price.

True False

59. An increase in exercise price results in an equal increase in the call option's price.

True False

60. The value of a call option increases as the volatility of the underlying stock price increases.

True False

20-14
61. It is possible to replicate an investment in a call option by a levered investment in the underlying asset.

True False

62. All else equal, options written on volatile assets are worth more than options written on safer assets.

True False

63. All else 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

Short Answer Questions

65. Define the term option.

66. Explain the difference between a European option and an American option.

20-15
67. Define the term call option.

68. Define the term put option.

69. Briefly discuss the usefulness of position diagrams.

20-16
70. Explain the main differences between position diagrams and profit diagrams.

71. Briefly explain what is meant by protective put.

72. Briefly explain what is meant by put-call parity?

20-17
73. Discuss the factors that determine the value of a call option.

74. Briefly explain how an option holder gains from an increase in 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
 Chapter 20 Understanding Options Answer Key

Multiple Choice Questions

1. Firms regularly use the following to reduce risk:

I) currency options; II) interest-rate options; III) commodity options

A. I only
B. II
only
C. III
only
D. I, II, and
III

Type: Medium

2. The following are examples of "disguised options":

I) acquiring growth opportunities;

II) ability of the firm to terminate a project when it is no longer profitable;
III) covenants within corporate securities that provide flexibility to change the terms of the securities

A. I only
B. II
only
C. I and III only
D. I, II, and
III

Type: Medium

20-19
3. An investor, in practice, can buy:

I) an option on a single share of stock;

II) options that are sold in blocks of 100 options per block;
III) a minimum order of 100 options on a share of stock

A. I only
B. II and III
only
C. II
only
D. III
only

Type: Easy

4. An option that can be exercised any time before its expiration date is called:

A. a European option.
B. an American option.
C. a call option.
D. a put option.

Type: Easy

5. The two principal options exchanges in the U.S. are the:

I) International Securities Exchange;

II) New York Stock Exchange;
III) NASDAQ;
IV) Chicago Board of Options Exchange

A. II and III
only
B. I and II only
C. I and IV only
D. III and IV
only

Type: Easy

20-20
6. The owner of a regular exchange-listed call-option on a stock:

A. has the right to buy 100 shares of the underlying stock at the exercise price.
B. has the right to sell 100 shares of the underlying stock at the exercise price.
C. has the obligation to buy 100 shares of the underlying stock at the exercise price.
D. has the obligation to sell 100 shares of the underlying stock at the exercise price.

Type: Medium

7. The owner of a regular exchange-listed put-option on a stock:

A. has the right to buy 100 shares of the underlying stock at the exercise price.
B. has the right to sell 100 shares of the underlying stock at the exercise price.
C. has the obligation to buy 100 shares of the underlying stock at the exercise price.
D. has the obligation to sell 100 shares of the underlying stock at the exercise price.

Type: Medium

8. In June 2017, an investor buys call options on Amgen stock with an exercise of price of $65 and
expiring in January 2019. If the stock price in June 2018 is $60, then these options are:

I) in-the-money; II) out-of-the-money; III) a LEAPS option

A. I only
B. II
only
C. III
only
D. II and III
only

Type: Easy

9. From a geometric viewpoint, how is the position diagram for a put option related to the diagram of a
call option on the same stock having the same exercise price and maturity?

A. The inverse of the call diagram

B. Unrelated to the call diagram no matter what the exercise price
C. The mirror image of the call diagram, reflected around the exercise price
D. Exactly the same as the call diagram for the given exercise price

Type: Difficult

20-21
10. In June 2017, an investor buys a put option on Genentech stock with an exercise price of $75 and
expiring in January 2019. If the stock price in July 2017 is $80, then this option is:

I) in-the-money
II) out-of-the-money
III) a LEAPS option

A. I only
B. II
only
C. III
only
D. II and III
only

Type: Easy

11. A put option gives the owner the right:

A. and the obligation to buy an asset at a given price.

B. and the obligation to sell an asset at a given price.
C. but not the obligation to buy an asset at a given price.
D. but not the obligation to sell an asset at a given price.

Type: Medium

12. The buyer of a call option has the right to exercise the option, but the writer of the call option has the:

A. choice to offset with a put option upon exercise.

B. obligation to deliver the shares at the exercise price.
C. choice to deliver shares or take a cash payoff.
D. obligation to deliver a put option upon exercise.

Type: Difficult

20-22
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. The option will extend for nine more months.

Type: Medium

14. The writer (seller) of a regular exchange-listed call-option on a stock:

A. has the right to buy 100 shares of the underlying stock at the exercise price.
B. has the right to sell 100 shares of the underlying stock at the exercise price.
C. has the obligation to buy 100 shares of the underlying stock at the exercise price.
D. has the obligation to sell 100 shares of the underlying stock at the exercise price.

Type: Medium

15. The writer (seller) of a regular exchange-listed put-option on a stock:

A. has the right to buy 100 shares of the underlying stock at the exercise price.
B. has the right to sell 100 shares of the underlying stock at the exercise price.
C. has the obligation to buy 100 shares of the underlying stock at the exercise price.
D. has the obligation to sell 100 shares of the underlying stock at the exercise price.

Type: Medium

16. The value of a put option at expiration equals the:

A. market price of the share minus the exercise price.

B. higher of the exercise price minus market price of the share and zero.
C. exercise price.
D. share price.

Type: Medium

20-23
17. Figure 1 depicts the:

A. position diagram for the buyer of a call option.

B. profit diagram for the buyer of a call option.
C. position diagram for the buyer of a put option.
D. profit diagram for the buyer of a put option.

Type: Medium

18. Figure 2 depicts the:

A. position diagram for the buyer of a call option.

B. profit diagram for the buyer of a call option.
C. position diagram for the buyer of a put option.
D. profit diagram for the buyer of a put option.

Type: Medium

20-24
19. Figure 3 depicts the:

A. position diagram for the writer (seller) of a call option.

B. profit diagram for the writer (seller) of a call option.
C. position diagram for the writer (seller) of a put option.
D. profit diagram for the writer (seller) of a put option.

Type: Medium

20. Figure 4 depicts the:

A. position diagram for the writer (seller) of a call option.

B. profit diagram for the writer (seller) of a call option.
C. position diagram for the writer (seller) of a put option.
D. profit diagram for the writer (seller) of a put option.

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) An investor who owns the stock and a put option;

II) An investor who has sold a put option and bought a call option;
III) An investor who owns the stock and has sold a call option;
IV) An 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 on the stock.
B. short-selling the stock and buying a call option on the stock.
C. writing (selling) a put option and buying a call option on the stock.
D. a T-bill.

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

27. Put-call parity can be used to show:

A. how valuable in-the-money put options can get.

B. how valuable in-the-money call options can get.
C. the precise relationship between put and call option prices given equal exercise prices and equal
expiration dates.
D. that the value of a call option is always twice that of a put given equal exercise prices and equal
expiration dates.

Type: Difficult

20-27
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 relation 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

30. Suppose the underlying stock pays a dividend before the expiration of options on that stock. This will:

I) increase the value of a call option;

II) increase the value of a put option;
III) decrease the value of a call option;
IV) decrease the value of a 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

20-28
32. For European options, the value of a put is equal to:

A. the value of a call minus the value of a share plus the present value of the exercise price.
B. the value of a call plus the value of a share plus the present value of the exercise price.
C. the value of the share minus the value of a call plus the present value of the exercise price.
D. the value of the share minus the present value of the exercise price plus the value of a call.

Type: Difficult

33. Consider the following data for a European option: Expiration = 6 months; Stock price = $80; Exercise
price = $75; Call option price = $12; Risk-free rate = 5% per year. Using put-call parity, calculate the
price of a put option having the same exercise price and expiration date.

A. $3.07
B. $5.1
9
C. $11.4
3
D. $3.42

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. All else equal, as the underlying stock price increases:

A. the put price increases.

B. the put price decreases.
C. there is no effect on put price.
D. the put price can either increase, decrease, or remain the same.

Type: Medium

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35. All else equal, as the underlying stock price increases:

A. the call price decreases.

B. the call price increases.
C. there is no effect on call price.
D. the call price can either increase, decrease, or remain the same.

Type: Medium

36. If the risk-free interest rate increases, then:

A. call option prices increase.

B. call option prices decrease.
C. call option prices remain the same.
D. call option prices can either increase, decrease, or remain the same.

Type: Difficult

37. If the volatility of the underlying asset decreases, then the:

A. value of the put option will increase, but the value of the call option will decrease.
B. value of the put option will decrease, but the value of the call option will increase.
C. value of both the put and call option will increase.
D. value of both the put and call option will decrease.

Type: Difficult

38. Which of the following features increase(s) the value of a call option?

I) A high interest rate;

II) A long time to maturity;
III) A higher volatility of the underlying stock price

A. I only
B. II
only
C. III
only
D. I, II, and
III

Type: Medium

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39. A call option has an exercise price of $150. At the option expiration 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

40. Relative to the underlying stock, a call option always has:

A. a higher beta and a higher standard deviation of return.

B. a lower beta and a higher standard deviation of return.
C. a higher beta and a lower standard deviation of return.
D. a lower beta and a lower standard deviation of return.

Type: Difficult

41. If the stock price follows a random walk, successive price changes are statistically independent. If σ 2 is
the variance of the daily price change, and there are t days until expiration, the variance of the
cumulative price change is:

A. σ2
B. (σ2) × (t)
C. (σ2)/t
D. (σ) × (t2)

Type: Difficult

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42. The value of any option (both call and put options) is positively related to the:

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

43. The value of a call option is positively related to the following:

I) underlying stock price; II) risk-free rate; III) time to expiration; IV) volatility of the underlying stock
price

A. I only
B. II
only
C. III
only
D. I, II, III, and
IV

Type: Medium

44. The value of a call option is negatively related to the:

I) exercise price; II) risk-free rate; III) time to expiration

A. I only
B. II
only
C. III
only
D. II and III
only

Type: Medium

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45. The value of a put option is positively related to the:

I) exercise price; II) time to expiration; III) volatility of the underlying stock price; IV) risk-free rate

A. I, II, and III

only
B. II, III, and IV
only
C. I, II, and IV
only
D. IV
only

Type: Medium

46. The value of a put option is negatively related to the:

I) stock price; II) volatility of the underlying stock price; III) exercise price

A. I only
B. II
only
C. I and II only
D. III
only

Type: Medium

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

True / False Questions

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48. A profit diagram implicitly neglects the time value of money.

TRUE

Type: Medium

49. An American call option gives its owner the right to buy stock at a fixed strike price during a specified
period of time.

TRUE

Type: Easy

50. A European option gives its owner the right to exercise the option at any time before expiration.

FALSE

Type: Medium

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 on the purchase of stock by buying a put option.

TRUE

Type: Difficult

55. Buying a stock and a put option, and lending the present value of the exercise price provide the same
payoff as buying a call option.

TRUE

Type: Difficult

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56. Call options can have a positive value at expiration even when the underlying stock is worthless.

FALSE

Type: Medium

57. For a European option: Value of call + PV(exercise price) = value of put + share price.

TRUE

Type: Medium

58. An increase in the underlying stock price results in an increase in a call option's price.

TRUE

Type: Medium

59. An increase in exercise price results in an equal increase in the call option's price.

FALSE

Type: Medium

60. The value of a call option increases as the volatility of the underlying stock price increases.

TRUE

Type: Medium

61. It is possible to replicate an investment in a call option by a levered investment in the underlying asset.

TRUE

Type: Medium

62. All else equal, options written on volatile assets are worth more than options written on safer assets.

TRUE

Type: Medium

63. All else equal, the closer an option gets to expiration, the lower the option price.

TRUE

Type: Medium

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64. Buying an in-the-money option will almost always produce a profit.

FALSE

Type: Medium

Short Answer Questions

65. Define the term option.

An option is defined as a right, but not an obligation, to buy or sell an underlying asset at a fixed price
during a specified period of time.

Type: Easy

66. Explain the difference between a European option and an American option.

A European option may be exercised only on its expiration date. An American option may be exercised
anytime up to the expiration date.

Type: Easy

67. Define the term call option.

A call option is defined as a right, but not an obligation, to buy an underlying asset at a fixed price
during a specified period of time.

Type: Easy

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68. Define the term put option.

A put option is defined as a right, but not an obligation, to sell an underlying asset at a fixed price
during a specified period of time.

Type: Easy

69. Briefly discuss the usefulness of position diagrams.

Position diagrams show payoffs at option exercise. Share price is plotted on the x-axis and option payoff
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.

Type: Medium

70. Explain the main differences between position diagrams and 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 include the cost of options. Profit
diagrams provide a clearer picture of profits and losses resulting from trading in options. They are also
helpful in analyzing trading strategies. However, profit diagrams do not distinguish the time value of the
purchase cost of the option from its payoffs, plotting both on the same diagram at their nominal
amounts.

Type: Difficult

71. Briefly explain what is meant by protective put.

The combination of a stock and a put option is known as a protective put. It effectively provides
insurance against a declining stock price. The exercise price of the put option provides a floor to
investment in the stock. The cost of this insurance is the price of the put option.

Type: Easy

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72. Briefly explain what is meant by put-call parity?

The relationship between the value of a European call option and the value of an equivalent put option
is called put-call parity. It shows that the payoff from purchasing a call option, and investing the present
value of its exercise price, equals the payoff from buying the stock and buying a put option on the stock.
Since these two payoffs at expiration are equal, it must cost the same to establish both positions. This
equivalence in cost to establish the positions is called put-call parity.

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. An increase in exercise price will
decrease the value of the option. An increase in any of the other factors will increase the value of the
option.

Type: Medium

74. Briefly explain how an option holder gains from an increase in 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, every dollar the stock price increases above the exercise price will increase the call option payoff
by the same amount. Hence, the call option holder gains from the increased volatility on the upside, but
does not lose on the down side. The reverse argument holds for the value of put options.

Type: Difficult

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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

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 immediately exercising the
option. In the case of a call, the stock price less the exercise price is almost always less than the value of
the option itself due to volatility and time. As such, the better choice is to sell the option—to someone
who desires the remaining time value of the option—and realize a higher profit.

Type: Difficult

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