Financial Risk Management

Quiz #6

1. Which of the following statements regarding options is correct?

A. Stock options are typically American-style options.
B. All options expire on the third Wednesday of the expiration month.
C. American-style options are less valuable than European-style options.
D. Index options are typically American-style options and are cash settled.

2. An investor owns a stock option that currently has a strike price of $100.
If the stock experiences a 4-to-1 split, the strike price becomes
A. $20.
B. $25.
C. $50.
D. $100.

3. Consider a European put option on a stock trading at $50. The put option has an expiration of
six months, a strike price of $40, and a risk-free rate of 5%. The lower bound and upper bound
on the put are closest to
A. $10, $40.00.
B. $10, $39.00.
C. $0, $40.00.
D. $0, $39.00.

The upper bound is the present value of the exercise price: $40 / 1.025 = $39.02. Because the put is out-
of-the-money, the lower bound is zero. (LO 37.b)

4. According to put-call parity for European options, purchasing a put option on ABC stock
would be equivalent to
A. buying a call, buying ABC stock, and buying a zero-coupon bond.
B. buying a call, selling ABC stock, and buying a zero-coupon bond.
C. selling a call, selling ABC stock, and buying a zero-coupon bond.
D. buying a call, selling ABC stock, and selling a zero-coupon bond.

The formula for put-call parity is p + S0 = c + PV(X). Rearranging to solve for the price of a put, we have p
= c − S0 + PV(X). (LO 37.c)

5. Consider an American call and put option on the same stock. Both options have the same one-
year expiration and a strike price of $45.
The stock is currently priced at $50, and the annual interest rate is 10%. Which of the following
amounts could be the difference in the two option values?
A. $4.95
B. $7.95
C. $9.35
D. $12.50

The upper and lower bounds are: S0 − X ≤ C − P ≤ S0 − PV(X) or $5 ≤ C − P ≤ $9.09. Only $7.95 falls within
the bounds. (LO 37.d)

6. A covered call position is

A. the simultaneous purchase of a call and the underlying asset.
B. the purchase of a share of stock with a simultaneous sale of a call on that stock.
C. the purchase of a share of stock with a simultaneous sale of a put on that stock.
D. the short sale of a stock with a simultaneous sale of a call on that stock.

7. Consider an option strategy where an investor buys one call option with an exercise price of
$55 for $7, sells two call options with an exercise price of $60 for $4, and buys one call option
with an exercise price of $65 for $2. If the stock price declines to $25, what will be the profit or
loss on the strategy?
A. −$3
B. −$1
C. $1
D. $2

The strategy described is a butterfly spread where the investor buys a call with a low exercise price, buys
another call with a high exercise price, and sells two calls with a price in between. In this case, if the
option moves to $25, none of the call options will be in-the-money, so the profit is equal to the net
premium paid, which is −$7 + (2 × $4) − $2 = −$1. (LO 38.b)

8. An investor is very confident that a stock will change significantly over the next few months;
however, the direction of the price change is unknown. Which strategies will most likely produce
a profit if the stock price moves as expected?
I. Short butterfly spread
II. Bearish calendar spread

A. I only
B. II only
C. Both I and II
D. Neither I nor II

A short butterfly spread will produce a modest profit if there is a large amount of volatility in the price of
the stock. A bearish calendar spread is a play using options with different expiration dates. (LO 38.c)

9. An investor constructs a straddle by buying an April $30 call for $4 and buying an April $30
put for $3. If the price of the underlying shares is $27 at expiration, what is the profit on the
position?
A. −$4
B. −$2
C. $2
D. $3
The sum of the premiums paid for the position is $7. With the underlying stock at $27, the put will be
worth $3, while the call option will be worthless. The value of the position is (−$7 + $3) = −$4. (LO 38.d)

10. An investor believes that a stock will either increase or decrease greatly in value over the
next few months but believes a down move is more likely. Which of the following strategies will
be most appropriate for this investor?
A. A protective put
B. An at-the-money strip
C. An at-the-money strap
D. A straddle

An at-the-money strip bets on volatility but is more bearish because it pays off more on the downside. A
straddle is possible, but a strip is even more appropriate. (LO 38.d)

11. 4-month European call option on a dividend-paying stock is currently selling for $5. The
stock price is $64, the strike price is $60, and a dividend of $0.80 is expected in 1 month. The
risk-free interest rate is 12% per annum for all maturities. What opportunities are there for an
arbitrageur?

PV of strike price = 60/(1+12%/12)^4 = $57.66

PV of dividend = 0.8/(1+1%)^1 = 0.79

Lower bound for call = 64 – 57.66 – 0.79 = $5.55

Call price = $5 < lower bound = $5.55 

• At t=0, an arbitrageur can short the stock and buy the call to provide a cash inflow of
$64 - $5 = $59
• Invest $0.79 of this at 12% for one month to pay the dividend of $0.80 in one month
• The remaining $58.21 is invested for four months at 12% per annum, it will grow to
58.21 x (1+ 1%)^4=$60.57

• At the end of four months t=4 months, the option expires.

• If ST > $60, the arbitrageur exercises the option for $60.00, closes out the short
position, and makes a profit of 60.57-60=$0.57
• If ST ≤ $60, buy the stock in the market and close out the short position. The
arbitrageur profit is at least 60.57-60=$0.57. For example if ST= $58, the
arbitrageur’s profit = 60.57-58=$2.57

12. A 1-month European put option on a non-dividend-paying stock is currently selling for
$2.50. The stock price is $47, the strike price is $50, and the risk-free interest rate is 6% per
annum. What opportunities are there for an arbitrageur?
Lower bound for put = 50/(1+6%/12)^1 - 47 = $2.75

Put price = 2.5 < lower bound  arbitrage opportunities

• An arbitrageur can borrow $49.5 to buy the stock and the put option
• In one month, the borrowed money will grow to 49.5 x (1+ 0.5%)^1=$49.75

• At the end of three months, the option expires.

If ST < $50, the arbitrageur exercises the option to sell the stock for $50.00, and use $50 to
repay the loan, and makes a profit of 50-49.75= $0.25

If ST ≥ $50, the arbitrageur do not exercise the option, sell the stock in the market, and use
the money to repay the loan. The profit is at least 50-49.75 =$ 0.25. For example if ST= $51,
the arbitrageur’s profit is 51-49.75 = 1.25

13. The price of a non-dividend-paying stock is $19 and the price of a 3-month European call
option on the stock with a strike price of $20 is $1. The risk-free rate is 4% per annum. What is
the price of a 3-month European put option with a strike price of $20?

Put-call parity:
p = c +PV(X) – So
= 1 + 20/(1+0.04/12)^3 – 19 = $1.8

14. Give an intuitive explanation of why the early exercise of an American put becomes more
attractive as the risk-free rate increases and volatility decreases.