CHAPTER 5: OPTION PRICING MODELS: THE BLACK-SCHOLES-MERTON MODEL

MULTIPLE CHOICE TEST QUESTIONS

The following information is given about otions on the sto!" of a !ertain !oman#$
S% & '( ) & '%
r! & %$%* T & %$+

'
& %$,+
No -ivi-en-s are e.e!te-$
Use this information to answer /uestions , through 0$
,$ 1hat value -oes the 2la!"3S!holes3Merton mo-el re-i!t for the !all4 56ue to -ifferen!es in roun-ing
#our !al!ulations ma# be slightl# -ifferent$ 7none of the above8 shoul- be sele!te- onl# if #our answer is
-ifferent b# more than ,% !ents$9
a$ +$(+
b$ ,$,%
!$ :$;(
-$ <$+%
e$ none of the above
'$ Suose #ou feel that the !all is overri!e-$ 1hat strateg# shoul- #ou use to e.loit the aarent
misvaluation4 56ue to -ifferen!es in roun-ing #our !al!ulations ma# be slightl# -ifferent$ 7none of the
above8 shoul- be sele!te- onl# if #our answer is -ifferent b# more than ,% shares$9
a$ bu# ;*, shares= sell ,=%%% !alls
b$ bu# ;%+ shares= sell ,=%%% !alls
!$ sell short ;*, shares= bu# ,=%%% !alls
-$ sell short ;%+ shares= bu# ,=%%% !alls
e$ none of the above
($ The ri!e of a ut on the sto!" is> 56ue to -ifferen!es in roun-ing #our !al!ulations ma# be slightl#
-ifferent$ 7none of the above8 shoul- be sele!te- onl# if #our answer is -ifferent b# more than ,% !ents$9
a$ %$0+
b$ 0$<:
!$ '$(+
-$ :$00
e$ none of the above
:$ To !onstru!t a ris"less he-ge= the number of uts er ,%% shares ur!hase- is> 56ue to -ifferen!es in
roun-ing #our !al!ulations ma# be slightl# -ifferent$ 7none of the above8 shoul- be sele!te- onl# if #our
answer is -ifferent b# more than %$%,$9
a$ %$;+0%
b$ %$':'%
!$ 3%$':0%
-$ 3%$<<'0
e$ none of the above
+$ The !all?s vega is> 56ue to -ifferen!es in roun-ing #our !al!ulations ma# be slightl# -ifferent$ 7none of the
above8 shoul- be sele!te- onl# if #our answer is -ifferent b# more than %$%+$9
a$ 3($%'
b$ %$%:<
!$ 3%$;*'
*
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-$ :$<;
e$ none of the above
<$ If the a!tual !all ri!e is ($;*= the imlie- stan-ar- -eviation is
a$ %$'+
b$ greater than %$'+
!$ less than %$'+
-$ infinite
e$ none of the above
;$ If we now assume that the sto!" a#s a -ivi-en- at a "nown !onstant rate of ($+ er!ent= what sto!" ri!e
shoul- we use in the mo-el4 56ue to -ifferen!es in roun-ing #our !al!ulations ma# be slightl# -ifferent$
7none of the above8 shoul- be sele!te- onl# if #our answer is -ifferent b# more than ,% !ents$9
a$ ''$<%
b$ ,*$<+
!$ '($%%
-$ ',$**
e$ none of the above
0$ If we now assume that the sto!" a#s a single -ivi-en- of '$'+ in three months= what sto!" ri!e shoul-
we use in the mo-el4 56ue to -ifferen!es in roun-ing #our !al!ulations ma# be slightl# -ifferent$ 7none of
the above8 shoul- be sele!te- onl# if #our answer is -ifferent b# more than ,% !ents$9
a$ ,;$;+
b$ '%$;+
!$ '%$%%
-$ '%$0%
e$ none of the above
*$ If the simle return on a Treasur# bill is 0$+ er!ent= the ris"3free rate in the 2la!"3S!holes3Merton mo-el
is
a$ 0$;; er!ent
b$ 0$*( er!ent
!$ 0$++ er!ent
-$ 0$'% er!ent
e$ none of the above
,%$ 1hi!h of the following variables in the 2la!"3S!holes3Merton otion ri!ing mo-el is the most -iffi!ult to
obtain4
a$ the volatilit#
b$ the ris"3free rate
!$ the sto!" ri!e
-$ the time to e.iration
e$ the e.er!ise ri!e
,,$ The binomial ri!e will theoreti!all# e/ual the 2la!"3S!holes3Merton ri!e un-er whi!h of the following
!on-itions4
a$ when the number of time erio-s is large
b$ when the otion is at3the3mone#
!$ when the otion is in3the3mone#
-$ when the otion is out3of3the3mone#
e$ none of the above
,'$ If the sto!" ri!e is ::= the e.er!ise ri!e is :%= the ut ri!e is ,$+:= an- the 2la!"3S!holes3Merton ri!e
using %$'0 as the volatilit# is ,$,,= the imlie- volatilit# will be
*
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,;*
a$ higher than %$'0
b$ lower than %$'0
!$ %$'0
-$ lower than the ris"3free rate
e$ none of the above
,($ 1hi!h of the following statements about the 2la!"3S!holes3Merton mo-el is not true4
a$ -e!reasing the volatilit# lowers the !all ri!e
b$ the e.e!te- sto!" ri!e la#s a role in the mo-el
!$ the ris"3free rate is !ontinuousl# !omoun-e-
-$ the mo-el is !onsistent with ut3!all arit#
e$ none of the above
,:$ 1hi!h of the following !hara!teristi!s of the 2la!"3S!holes3Merton mo-el is not !orre!t4
a$ it is a -is!rete time mo-el
b$ it is the limit of the binomial mo-el
!$ it is a !ontinuous time mo-el
-$ it gives the ri!e of a Euroean otion
e$ none of the above
,+$ 1hi!h of the following assumtions of the 2la!"3S!holes3Merton mo-el is not !orre!t4
a$ the sto!" volatilit# is !onstant
b$ the sto!" return follows a normal -istribution
!$ there are no transa!tion !osts
-$ there are no ta.es
e$ none of the above
,<$ 1hi!h of the following statements about the -elta is not true4
a$ it ranges from Bero to one
b$ it !onverges to Bero or one at e.iration
!$ it is given b# N5-,9 in the 2la!"3S!holes3Merton mo-el
-$ it !hanges slowl# near e.iration if the otion is at3the3mone#
e$ none of the above
,;$ 1hi!h of the following 7Cree"s8 is not a measure of the otionDs sensitivit# to a !hange in one of its inut
values4
a$ -elta
b$ gamma
!$ rho
-$ theta
e$ sigma
,0$ 1hi!h of the following statements is true about the relationshi between the otion ri!e an- the ris"3free
rate4
a$ a !all ri!e is nearl# linear with rese!t to the ris"3free rate
b$ a !all ri!e is highl# sensitive to the ris"3free rate
!$ the ris"3free rate affe!ts a !all but not a ut
-$ the ris"3free rate -oes not affe!t a !all ri!e
e$ none of the above
,*$ The relationshi between the volatilit# an- the time to e.iration is !alle- the
a$ volatilit# smile
b$ volatilit# s"ew
!$ term stru!ture of volatilit#
*
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-$ theta
e$ none of the above
'%$ 1hat is the reason for e.e!uting a gamma he-ge4
a$ the volatilit# !an !hange
b$ the sto!" ri!e !an ma"e a large move
!$ the sto!" ri!e moves are too small for a -elta he-ge to wor"
-$ there is no true ris"3free rate
e$ none of the above
',$ 1hi!h of the following statements about the volatilit# is not true4
a$ the imlie- volatilit# often -iffers a!ross otions with -ifferent e.er!ise ri!es
b$ the imlie- volatilit# e/uals the histori!al volatilit# if the otion is !orre!tl# ri!e-
!$ the imlie- volatilit# is -etermine- b# trial an- error
-$ the imlie- volatilit# is nearl# linearl# relate- to the otion ri!e
e$ none of the above
''$ The relationshi between the otion ri!e an- the e.er!ise ri!e is !alle-
a$ the gamma
b$ the vega
!$ the omega
-$ the Beta
e$ none of the above
'($ 1hat haens when the volatilit# is Bero in the 2la!"3S!holes3Merton mo-el4
a$ the otion ri!e !onverges to either Bero or the lower boun-
b$ the otion ri!e !onverges to the intrinsi! value
!$ the otion automati!all# e.ires out of the mone#
-$ the gamma an- -elta !onverge
e$ none of the above
':$ 1hi!h of the following is not !orre!t about a !allDs gamma4
a$ it is the same as a utDs gamma
b$ it is large when the !all is at3the3mone#
!$ it !an be viewe- as a measure of the ris" of the -elta
-$ it is a sour!e of ris" that !an be he-ge- onl# b# using another otion
e$ none of the above
'+$ 1hi!h of the following statements is in!orre!t about the histori!al volatilit#4
a$ if use- in the 2la!"3S!holes3Merton mo-el= it gives the !urrent mar"et ri!e
b$ it is base- on the volatilit# of the log return on the sto!"
!$ it re/uires a samle of re!ent returns
-$ it shoul- be !onverte- to an annualiBe- volatilit#
e$ none of the above
'<$ @ he-ge ortfolio is establishe- an- maintaine- b# !onstantl# a-Eusting the relative roortions of sto!" an-
otions= a ro!ess referre- to as
a$ a!tivel# managing
b$ !ontinuous re!on!iliation
!$ mar"ing to mar"et
-$ -#nami! tra-ing
e$ none of the above
*
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';$ The stan-ar- normal ran-om variable use- in the !al!ulation of !umulative normal robabilities within the
2la!"3S!holes3Merton otion ri!ing mo-el is
a$ the lognormal -istribution
b$ the -, an- -' statisti!
!$ the B statisti!
-$ the f -istribution
e$ none of the above
'0$ The attern of volatilit# a!ross e.er!ise ri!es is often !alle-
a$ the ri!e3flu!tuation grah
b$ the volatilit# smile
!$ the term stru!ture of imlie- volatilit#
-$ the s"ew
e$ none of the above
'*$ The 2la!"3S!holes3Merton mo-el for Euroean uts= obtaine- b# al#ing ut3!all arit# to the 2la!"3
S!holes3Merton mo-el for Euroean !alls= is !ustomaril# e.resse- b# whi!h of the following>
a$

P = Xe
r
c
T
N(d
2
) S
0
N(d
1
)
b$

P = X(1+r)
T
N(d
2
) S
0
N(d
1
)
!$

P = X(1+r)
T
N(d
1
) S
0
N(d
2
)
-$

P = Xe
r
c
T
N(d
1
) S
0
N(d
2
)
e$ none of the above
(%$ The imlie- volatilit# is obtaine- b# fin-ing the stan-ar- -eviation that= when use- in the 2la!"3S!holes3
Merton mo-el= ma"es the
a$ mo-el ri!e e.ire at Bero
b$ mo-el ri!e e/ual the mar"et ri!e of the otion
!$ mo-el ri!e su!h that it e.!ee-s !urrentl# tra-e- mar"et otion values
-$ mo-el ri!e e/ual the intrinsi! value of the un-erl#ing sto!"
e$ none of the above
*
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CHAPTER 5: OPTION PRICING MODELS: THE BLACK-SCHOLES-MERTON MODEL
TAUEFG@LSE TEST QUESTIONS
T G ,$ The 2la!"3S!holes3Merton mo-el is the -is!rete time limit to the binomial mo-el$
T G '$ In the 2la!"3S!holes3Merton mo-el= sto!" ri!es are assume- to behave ran-oml#$
T G ($ The values of N5-,9 an- N5-'9 are !alle- ris" neutral robabilities$
T G :$ @n otion?s gamma reresents the ris" of the -elta !hanging$
T G +$ The binomial mo-el alwa#s gives the same otion ri!e as the 2la!"3S!holes3Merton
mo-el$
T G <$ The 2la!"3S!holes3Merton mo-el assumes that the volatilit# -oes not !hange throughout
the otion?s life$
T G ;$ One of the variables that influen!es the ri!e of the otion is the e.e!te- return on the
sto!"$
T G 0$ The otion?s rate of time value -e!a# is reresente- b# its theta$
T G *$ The otion?s -elta is aro.imatel# the !hange in the otion ri!e for a !hange in the
sto!" ri!e$
T G ,%$ Sin!e -ivi-en-s !oul- trigger an earl# e.er!ise of an @meri!an !all= the 2la!"3S!holes3
Merton -ivi-en- a-Eustment will rovi-e the !orre!t ri!e of an @meri!an !all$
T G ,,$ The 2la!"3S!holes3Merton otion ri!e is relativel# insensitive to !hanges in the ris"3
free rate$
T G ,'$ One of the inuts to the 2la!"3S!holes3Merton mo-el is the volatilit# over a re!ent time
erio-$
T G ,($ 1hen the ris"Hfree rate is Bero= the 2la!"HS!holes formula !onverges to the intrinsi!
value$
T G ,:$ In or-er to !omute the imlie- volatilit#= one must for!e the otion to be !orre!tl#
ri!e- b# the mo-el$
T G ,+$ The 2la!"3S!holes3Merton mo-el !ombine- with ut3!all arit# give the theoreti!al
ri!e of an @meri!an ut otion$
T G ,<$ Iega !atures the !ombine- effe!ts of time -e!a# an- volatilit#$
T G ,;$ The volatilit# smile is the relationshi between imlie- volatilit# an- histori!al
volatilit#$
T G ,0$ The 2la!"3S!holes3Merton formula re/uires !umulative robabilities from the
lognormal -istribution$
T G ,*$ In the term stru!ture of volatilit#= the forwar- volatilit# is the e.e!te- future volatilit#$
*
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T G '%$ @ ris"less he-ge re/uires more shares of sto!" than !all otions$
T G ',$ @n aro.imate imlie- volatilit# for an at3the3mone# !all !an be solve- -ire!tl#$
T G ''$ The imlie- volatilities of a !all an- a ut with the same terms shoul- be the same$
T G '($ The histori!al volatilit# is the same value as the imlie- volatilit#$
T G ':$ The otionDs sensitivit# to an interest rate !hange is !alle- rho$
T G '+$ The time to e.iration of an otion is base- on a (<%3-a# #ear$
T G '<$ The 2la!"3S!holes3Merton mo-el !an be use- with !urren!# otions b# rela!ing the
-ivi-en- #iel- with the foreign interest rate$
T G ';$ The 2la!"3S!holes3Merton mo-el is the best mo-el for valuing all t#es of otions$
T G '0$ The 2la!"3S!holes3Merton mo-el assumes the un-erl#ing instrument movement is
lognormall# -istribute-$
T G '*$ The 2la!"3S!holes3Merton mo-el assumes that the un-erl#ing !oman# never goes
ban"rut$
T G (%$ The level of li/ui-it# of the un-erl#ing instrument will influen!e the behavior of relate-
otions$
*
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,0: