Student

23
Student: ___________________________________________________________________________
1. The seller of a put option is betting that the market value of the stock will decrease.
True False
2. In 2007 the SEC investigated a number of instances where companies had backdated the stock options
that they granted to senior executives.
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True False
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3. Stock options give recipients a right to buy the company stock at a set (exercise) price. The exercise price
is usually the stock's 4 p.m. price on the date of the grant, an average of the day's high and low, or the 4
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p.m. price the day before.
True False
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4. The probability of seeing all six of an executive's stock-option grants from 1995 to 2002 were dated just
before a rise in the stock price, often at the bottom of a steep drop is as small as one in 300 billion.
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True False
5. The put-call parity holds only if an investor plans to hold the options to maturity.
True False
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The price of a call option increases while its exercise price decreases.
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True False
7. The Financial Accounting Standards Board (FASB) requires that companies recognize the fact that
employee stock options are valuable and therefore are an expense just like salaries and wages.
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True False
8. FASB's Statement 123 stipulates that companies must use an option valuation model to estimate the fair
value of any option grants and then deduct this value when calculating profits.
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True False
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9. The FASB rule requiring expensing of the stock options only became compulsory in 2005.
True False
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10. Callable bonds allow the investor to redeem the bond at face value or let the bond remain outstanding
until maturity.
True False
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11. The put option that comes with the puttable bonds makes the bond more valuable.
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True False
12. Convertible bonds give the investor the option to buy the firm's stock in exchange for the value of the
underlying bond.
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True False
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13. Callable bonds give the option to the issuing firm and hence reduce the value of the bond.
True False
14. The longer the time until expiration of a call option, the greater the value of the option.
True False
15. Only at the expiration date can an investor expect to find the value of call options above their lower
bound.
True False
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16. Stock price volatility is beneficial to option holders.
True False
17. Unlike call options, the option to abandon a real asset project does not become more valuable as time to
expiration increases.
True False
18. A callable bond gives the issuer a potentially valuable option in the case of changing interest rates.
True False
19. At expiration a call option will have no value if the stock price is less than exercise price.
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True False
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20. At expiration a put option will have no value if the stock price is greater than the exercise price.
True False
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21. A protective put is a costless way of eliminating the downside risk if holding stock.
True False
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22. The value of a call option increases as the strike price increases.
True False
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23. When the stock price is very high compared to the exercise price, the call option premium approximates
the difference between the stock price and strike price.
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True False
24. Warrants are long-term call options on a company's stock issued by an organized stock exchange.
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True False
25. A warrant is a long-term call option which is "in the money" at the time of issuance.
True False
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26. A callable bond will have a lower value than a straight bond with the same coupon rate and maturity.
True False
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27. The floor of a convertible bond will be the value of the underlying bond.
True False
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28. The value of a convertible bond is less than the value of a straight bond with similar coupon and
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maturity.
True False
29. Since the value of a straddle position can't be negative, then a straddle is a costless way of profiting from
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market movements.
True False
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30. The value of both call and put options increase as the variability of the stock price increases.
True False
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31. If the owner of a call option with a strike price of $35 finds the stock to be trading for $42 at expiration,
then the option:
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A. expires worthless.
B. will not be exercised.
C. is worth $7 per share.
D. cost too much initially.
32. Which of the following is true for the owner of a call option?
A. The loss potential is unlimited.
B. The profit potential is unlimited.
C. The premium exceeds the strike price.
D. There is no expiration date, unless the option is a European call.
33. Which of the following statement about a straddle is incorrect?
A. The position of holding a call and a put is called a straddle.
B.The strategy works as follows: if the stock price falls, the put will be profitable; if the stock price rises,
the call will be profitable.
C. The payoff and profit on a straddle forms a V curve.
D. A straddle is most profitable for its holder when the stock price remains stable (with little deviation
from the exercise price).
34. The difference between an American call option and a European call option is:
A. the European call has a final exercise date.
B. the American call trades only on domestic stocks.
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C. the European call can be exercised only on one day.
D. the American call generates profits regardless of which direction the stock moves.
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35. What is the option buyer's total profit or loss per share if a call option is purchased for a $5 premium, has
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a $50 exercise price, and the stock is valued at $53 at expiration?
A. ($5)
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B. ($2)
C. $3
D. $8
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36. Calculate the profit per share for an investor that exercises a put option with a strike price of $60 when
the stock is selling for $46 and the premium for the put option was $4.
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A. ($14)
B. ($10)
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C. $10
D. $18
37. Which of the following option traders receive, rather than pay, a premium?
A. Option sellers
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B. Option buyers
C. Both option sellers and buyers
D. Neither buyers nor sellers receive premiums
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38. Which of the following is true for an investor that owns a share of stock and has purchased a put option
on the stock?
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A. The investor profits when the stock decreases in value.

B. Maximum loss is the price of the option premium.
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C. The investor is protected against upside potential.

D. Increases in stock value go to the seller of the put.
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39. What is the profit per share for an investor who has purchased a share of stock and two put options with
an exercise price of $40, given that the purchase price of the stock was $42, each put cost $2 per share,
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and the stock was valued at $30 at expiration?

A. ($16)
B. ($6)
C. ($4)
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D. $4
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40. Which combination of positions will tend to protect the owner from downside risk?
A. Buy the stock and buy a call option.
B. Sell the stock and buy a call option.
C. Buy the stock and buy a put option.
D. Buy the stock and sell a put option.
41. If you feel strongly that a stock price will move, but are unsure of the direction, you could buy the stock
and:
A. buy both a put and a call.
B. sell both a put and a call.
C. buy a put and sell a call.
D. buy two puts.
42. A stock is currently selling for $70 per share and its call option has a $90 exercise price. What is the
lower limit on the value of the call option?
A. ($20)
B. 0
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C. $10
D. $20
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43. Why is the value of a call option said to increase as the interest rate increases?
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A. The stock seller must pay the call owner more interest.
B. The present value of the strike price is reduced.
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C. As interest rates increase, stock prices increase.
D. Interest rate increases reduce the option premium.
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44. Owning a call option that has a high probability of being exercised is said to be equivalent to owning the
stock. In which way is owning a call not equivalent to owning the stock?
A. Option holders pay no income taxes.
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B. Stockholders do not have capped (restricted) profits.
C. Option holders do not receive dividends.
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D. Stockholders cannot sustain losses.
45. How much must the stock be worth at expiration in order for a call holder to break even if the exercise
price is $50 and the call premium was $4?
A. $46
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B. $50
C. $52
D. $54
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46. What is the worst-case profitability scenario for an investor who sold a call on the firm's stock for a
premium of $10 and a strike price of $100?
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A. $90 per share profit

B. $10 per share profit
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C. $0 per share profit (break-even)

D. Unlimited losses
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47. Which of the following call options would command the higher premium, other things equal?
A. October 1996 expiration, $45 strike price
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B. December 1996 expiration, $40 strike price

C. March 1997 expiration, $45 strike price
D. June 1997 expiration, $40 strike price
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48. A decrease in which of the following terms will cause an increase in the call value of an option?
A. Interest rates
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B. Time to maturity
C. Exercise price
D. Volatility of the stock
49. The payoffs from holding a call option can be replicated by:
A. borrowing money to buy a put option.
B. borrowing money to invest in the stock.
C. simultaneously selling a call and buying a put.
D. simultaneously buying a share and buying a put.
50. The major difference between options on real assets and options on financial assets is that options on:
A. financial assets are costly.
B. financial assets have a higher probability of positive payoff.
C. real assets are implicit, rather than explicit.
D. real assets are not influenced by price volatility.
51. The option to abandon a project investing in real assets can be considered to have a strike price equal to
the:
A. historical cost of the asset.
B. market value of the asset at abandonment.
C. forgone revenues anticipated from the project.
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D. forgone interest on the bonds used to finance the real assets.
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52. Investors who hold warrants essentially have a:
A. put option on the firm's bonds.
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B. put option on the firm's equity.
C. call option on the firm's bonds.
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D. call option on the firm's equity.
53. The conversion ratio for a convertible bond equals the:
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A. ratio of bond value to stock price at conversion.
B. number of bonds necessary to convert into one share of stock.
C. number of shares of stock that can be exchanged for one bond.
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D. floor value beneath which the bond price cannot fall.
54. If a $1,000 convertible bond with a market value of $950 has a conversion ratio of 25 when the firm's
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stock is selling for $36 per share, then:
A. the bond will be converted immediately.
B. the bond is violating its "price floor."
C. conversion now would give the investor a profit of $900.
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D. the conversion value of the bond is $900.

55. If a $1,000 convertible bond has a conversion ratio of 50 and the firm's equity is currently selling for $22
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per share, then the:

A. bond should trade for $900.
B. bond should trade for $1,000
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C. bond should trade for $1,100.

D. firm will have already converted the bond.
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56. Which of the following conditions will typically be present when a firm calls a bond prior to maturity?
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A. The firm is in poor financial health.

B. Interest rates have risen substantially since the bond was issued.
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C. Interest rates have fallen substantially since the bond was issued.
D. The call option is ready to expire.
57. The value of a callable bond equals the value of a straight bond:
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A. plus the value of the bondholder's call option.

B. minus the value of the bondholder's call option.
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C. plus the value of the issuer's call option.

D. minus the value of the issuer's call option.
58. What is the value of a convertible bond with a conversion ratio of 25, face value of $1,000, coupon of
10% and yield of 10%? Common stock of this firm is currently selling at $35.
A. $875
B. $1,000
C. $1,125
D. $1,875
59. Which of the following statements is correct:
A. A convertible bond will be priced less than a similar callable bond.
B. A convertible bond will be priced more than a similar callable bond.
C. Similar callable and convertible bonds will have the same price.
D. Warrants are always priced more than convertible bonds.
60. Stock options have been traded on exchanges since:
A. the founding of the New York Stock Exchange.
B. options were discovered in 1946.
C. the early part of the 1970s.
D. just before the stock market crash in 1987.
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61. Which of the following is correct for the owner of a June call, valued at $3, on XYZ Corp. with a strike
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price of $60? XYZ Corp. currently trades at $55.
A. XYZ is expected to go to $63 per share.
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B. The option cannot currently be exercised.
C. The option owner's current profit is $3 per share.
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D. The option may expire without value.
62. It is May 19th and you own a June, European call on ABC Corp. with an exercise price of $50. The
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option trades at $40 and ABC is trading at $86. What should you do?
A. Exercise the option now and take the profits.
B. Buy more options on ABC Corp.
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C. Sell your ABC stock before its price declines.
D. Sit and wait until the June expiration.
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63. At what point on the graph of possible values for a call option does the buyer break-even financially?
A. When stock price equals strike price
B. At any point on the upward-sloping segment of the graph
C. When stock price equals cost of the option plus strike price
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D. At the point where the graph intercepts the y-axis

64. Which of the following is correct for the owner of a September put, valued at $20, on CBA Corp. with a
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strike price of $80? CBA currently trades at $67.

A. The option will continue to gain value until its September expiration.
B. The owner profits $13 per share by exercising now.
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C. Further decreases in CBA stock price will be translated directly into additional option value.
D. $20 is the maximum value for this option.
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65. Option buyers can have a(n) _____ of exercising their options. Options sellers can have a(n) _____ of
exercising their options.
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A. obligation; obligation
B. obligation; right
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C. right; right
D. right; obligation
66. Joe sold a put option on ZZZ Corp. with an exercise price of $40. The option expires tomorrow and ZZZ
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is currently trading at $28 per share. The option premium was $4 per share. What is Joe's profit <loss>
per share if the option is exercised tomorrow?
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A. ($16)
B. ($8)
C. $8
D. $16
67. Jennifer sold a call option on XXX Corp. with an exercise price of $50. The option expires tomorrow and
XXX is currently trading at $40. The option premium was $3 per share. What is Jennifer's expected profit
<loss> per share at tomorrow's expiration?
A. ($3)
B. $3
C. $7
D. $10
68. The payoffs from investing in options are designed so that:
A. both buyers and sellers can profit.
B. the seller's (buyer's) gain is the buyer's (seller's) loss.
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C. roughly 20% of sellers and 50% of buyers profit.
D. few buyers or sellers profit; they buy "insurance."
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69. Under what circumstance will the buyer of a put option be asked to perform his or her obligation?
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A. When the stock price has declined below the strike price
B. When the stock price has increased above the strike price
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C. The put buyer has an equal obligation regardless of the relationship between stock and strike prices.
D. The put buyer has no obligation whatsoever.
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70. Which of the following statements is correct for an investor who has purchased "portfolio insurance," by
owning the stock and buying a put option on the stock?
A. The investor profits when the stock price declines.
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B. Maximum profitability occurs when stock price equals strike price.
C. Value per share can decline no further than the strike price less the value of the option premium.
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D. The option will certainly be exercised.
71. Under which condition does a call option approach its upper bound?
A. When the stock price is far above the strike price
B. When the stock price is closest to the strike price
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C. When the stock price is approaching zero

D. When the option is approaching its expiration time
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72. When does a change in the value of a call option come the closest to matching the price change in a share
of stock?
A. When the stock is priced far above the strike price
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B. When the stock is priced far below the strike price

C. When the stock is priced very near the strike price
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D. Changes in call value always come close to matching changes in stock price.
73. At what point is the payoff from owning a call option on a stock greater than the payoff from owning the
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stock itself?
A. When stock price exceeds strike price at expiration
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B. When strike price exceeds stock price at expiration

C. When stock price equals strike price at expiration
D. Call payoff never exceeds stock payoff.
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74. When the stock price has risen above the exercise price, the value of a call option is equal to the stock
price:
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A. less the value of the dividend.

B. less the value of the option.
C. less the present value of the exercise price.
D. less the exercise price.
75. The value of a call option increases as the time to expiration increases because:
A. the exercise price continually decreases.
B. opportunity increases to surpass exercise price.
C. dividends accumulate while waiting to be paid.
D. the option can be repeatedly exercised.
76. Stocks that have more volatile price changes have more valuable call options because call holders:
A. capture upside potential without downside risk.
B. realize that volatility decreases the present value of the exercise price.
C. have too little variability in the exercise price.
D. have transferred all risk to put holders.
77. Of the following four put options that can be purchased on a stock, which would you expect to have the
highest price?
A. September put; $65 exercise price
B. September put; $75 exercise price
C. December put; $65 exercise price
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D. December put; $75 exercise price
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78. A share of stock is currently priced at $20 and will change with equal likelihood to either $50 or $10.
A call option with a $25 exercise price is available on the stock. How many shares of stock must be
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purchased to replicate the payoff from owning one call option?
A. .50 shares
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B. .75 shares
C. .80 shares
D. 1.25 shares
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79. It has been determined that 0.5 shares of stock should be purchased with borrowed funds to replicate the
payoff to one call option. What is the option's strike price if the stock could range in value from $110 to
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$10 at the expiration of the option?
A. $40
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B. $50
C. $60
D. $70
80. Firms spend an increasing amount of time evaluating real options, which are:
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A. options on real assets such as an option to abandon.

B. call and put options traded on organized exchanges.
C. call options such as warrants and convertible bonds.
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D. put options such as held by shareholders of a firm with financial leverage.

81. Corporations that attach warrants to their bonds are hoping to:
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A. sell equity without paying flotation costs.

B. convert the bonds into stock at a later date.
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C. reduce the cost of debt by increasing bond prices.

D. increase the price of their shares.
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82. If a convertible bond can be thought of as a straight bond with a call option, then the call is owned by the
_____ and the strike price is the _____.
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A. debt issuer; stock price

B. debt issuer; straight bond value
C. bond investor; stock price
D. bond investor; straight bond value
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83. Why should a convertible bond always be valued at more than its bond value or its conversion value up
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until maturity?
A. The bond holder is receiving higher interest rates.
B. The conversion value does not have an upper bound.
C. The conversion ratio may be decreased.
D. The bond does not have to be given up to exercise the option.
84. What is the minimum value of the call option on a convertible bond with a conversion ratio of 30 if the
bond offers a 9% coupon, has 10 years until maturity and market interest rates are 9% for comparable
bonds? The stock is currently priced at 35.
A. $0
B. $5
C. $50
D. $65
85. Which of the following is correct concerning callable bonds?
A. There is an upper bound on the bond's price.
B. Their prices are higher than for straight bonds.
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C. Their attraction to the issuer increases as interest rates increase.
D. The bond investor owns the call option.
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86. Which of the following statements is correct concerning call options?
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A. Value of a call option at expiration will be greater than the stock price.
B. Value of a call option at expiration will be equal to the exercise price.
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C. Value of a call option at expiration will be equal to the difference between the stock price and exercise
price.
D. Value of a call option at expiration will be equal to zero.
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87. IBM shares are currently selling at $75. The premium on a call option on IBM shares with an exercise
price of $60 will be:
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A. less than $15
B. greater than $15
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C. equal to $15
D. zero
88. You are currently holding a call option on a stock with a exercise price of $80. If the current stock price is
$60, your net proceeds by exercising this option will be:
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A. ($20)
B. $0
C. $20
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D. $60
89. Three months back you bought for $4 a put option on a stock with an exercise price of $100. If the stock
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price at expiration of this option is $92, what is your return on investment?

A. 200%
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B. 150%
C. 100%
D. 50%
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90. Recently you bought a call and a put option on a stock with a common exercise price of $75. The call
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premium was $5 and the put premium was $3. You will make money from this position if the stock price
is:
A. greater than $75 but less than $78
B. greater than $75 but less than $80
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C. greater than $72 but less than $75

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D. less than $67 or greater than $83

91. A stock is selling at $85 at the expiration of an option contract. Which of the following options will most
likely be exercised?
A. Buyer of a call option with exercise price of $65.
B. Buyer of a put option with exercise price of $65.
C. Buyer of a call option with exercise price of $80.
D. Buyer of a put option with exercise price of $85.
92. Which of the following changes will decrease the value of a call option?
A. An increase in stock price.
B. An increase in strike price.
C. An increase in stock price volatility.
D. An increase in interest rates.
93. An investor who is buying a put option is expecting:
A. stock prices to go up.
B. stock prices to go down.
C. interest rates to go up.
D. interest rates to go down.
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94. On March 30 you are holding a call option on a stock (exercise price of $60), which will expire on March
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31. The closing price of the stock on March 30 is $59. What is the value of your call option?
A. $1
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B. ($1)
C. Very little
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D. Zero
95. A firm is planning to issue a callable bond with 8% coupon and 10 years to maturity. A straight bond with
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similar coupon is priced at $1,000. If the value of the issuer's call option is estimated to be $60, what is
the value of the callable bond?
A. $940
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B. $970
C. $1,000
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D. $1,060
96. Adding warrants as a 'sweetener' to bonds will:
A. reduce the value of the bond
B. increase the coupon rate of the bond
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C. increase the value of the bond

D. make the bond more risky
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97. A homeowner can refinance the mortgage loan on the house at a lower rate when the interest rates go
down. The right to refinance at a lower rate is a(n):
A. put option
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B. call option
C. option to expand
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D. None of these
98. The lower limit on value of a call option is:
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A. zero
B. less than zero
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C. stock price minus exercise price

D. exercise price
99. An investor can create a straddle position by doing the following:
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A. buy a stock and write a call option.

B. buy a stock and buy a call option.
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C. buy a stock and buy a put option.

D. buy a call option and a put option with the same exercise price.
100.A writer of a call option expects the stock price to:
A. decrease
B. increase
C. remain unchanged
D. cash dividends quarterly
101.Calculate the return on exercising a put option which was purchased for $10, with an exercise price of
$85. The stock price at expiration is $81.
A. (60%)
B. 60%
C. 30%
D. (30%)
102.Generalize the formulas for determining the value of the following four option types: buying a call,
buying a put, writing a call, writing a put.
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103.What price risk is an investor exposed to if she owns a share of stock and has purchased a put option on
the stock?
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104.Define and briefly explain the relationship between value of a call option and the following five factors:
Stock price, exercise price, interest rate, time to expiration, volatility of stock price.
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105.Assume that the current stock price is $50 per share, that call options can be purchased with an exercise
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price of $60 per share, that bank loans can be obtained for a 10% nominal rate, and that at expiration
of the option in three months, the stock will either be valued at $30 or $70. Show that it is possible to
replicate the stock payoff by borrowing and buying a call option.
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106.How, in general, is value derived from options on real assets?
107.Why would bondholders be willing to pay more for bonds that contain warrants?
108.Assist the holder of a $1,000 par value convertible bond in determining whether to convert, given that the
conversion ratio is 15.5 and that the stock is currently selling for $70 per share. Calculate both the bond
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value and conversion value.
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109.What is a callable bond and how is its value determined?
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110.Assume that a share of stock is currently selling for $80, that a call option can be purchased for an $8
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premium and an exercise price of $80, and that a put option can be purchased for a $4 premium and an
exercise price of $80. If the investor buys one share, one call, and one put option, what type of price
movements will be desirable? Illustrate the investor's potential profits.
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111.Investors who buy calls or puts have a cap on their possible losses from holding options. Specifically,
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they cannot lose more than the value of their premium. How does this differ for investors who sell
options?
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112.For each of the following option and securities combinations show what the payoff would be when the
option expires. Assume that each option has the same exercise price and expiration date.
a. Buy a call and invest the present value of the exercise price in a bank deposit.
b. Buy a share and a put option on the share.
c. Buy a share, buy a put option on the share, and sell a call option on the share.
d. Buy a call option and a put option on the share.
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113.Circular File stock is selling for $25 a share. You see that call options on the stock with exercise price of
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$20 are selling at $3. What should you do? What will happen to the option price as investors identify this
opportunity? Then you observe that put options on Circular File with exercise price $30 are selling for $4.
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What should you do?
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114.A 10-year maturity convertible bond with a 6 percent coupon on a company with a bond rating of Aaa
is selling for $1,050. Each bond can be exchanged for 20 shares, and the stock price currently is $50 per
share. Other Aaa-rated bonds with the same maturity would sell at a yield to maturity of 8 percent. What
is the value of the bondholders' call option? Why is the bond selling for more than the value of the shares
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it can be converted into?

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ar
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115.A real estate developer buys 70 acres of land in a rural area, planning to build a subdivision on the land
if and when the population from the city begins to expand into the area. If population growth is less than
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anticipated, the developer believes that the land can be sold to a country club that would build a golf
course on the property.
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a. In what way does the possibility of sale to the country club provide a put option to the developer?
b. What is the exercise price of the option? The asset value?
c. How does the golf course option increase the NPV of the land project to the developer?
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116.Assume that call options on Microsoft stock with the same exercise date in October are available with
exercise prices $45, $55, and $65. Also assume that the price of the middle call were the average of the
other two calls. Show that if you sell two of the middle calls and use the proceeds to buy one each of the
other calls, your proceeds in October may be positive but cannot be negative despite the fact that your net
outlay today is zero. What can you deduce from this example about option pricing?
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117.How does the price of a put option respond to the following changes, other things being equal? Does the
put price go up or down?
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a. Stock price increases.
b. Exercise price is increased.
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c. Risk-free interest rate increases.
d. Expiration date of the option is extended.
e. Volatility of the stock price falls.
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f. Time passes, so the option's expiration date comes closer.
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118.What Is the payoff to buyers and sellers of call and put options?
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119.What are the determinants of option values?

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120.What options may be present in capital Investment proposals?

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121.What options may be provided in financial securities?
122.In December 2007 a call option on Google stock with a June 2008 expiration and an exercise price of
$720 sold for $80.50. If you bought this call, and find that Google share is sold for $840 in June. What
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would be the proceeds and return from exercising the call?
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23 Key
1. FALSE
2. TRUE
3. TRUE
4. TRUE
5. TRUE
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6. TRUE
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7. TRUE
8. TRUE
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9. TRUE
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10. FALSE
11. TRUE
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12. TRUE
13. TRUE
14. TRUE
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15. FALSE
16. TRUE
17. FALSE
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18. TRUE
19. TRUE
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20. TRUE
21. FALSE
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22. FALSE
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23. TRUE
24. FALSE
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25. FALSE
26. TRUE
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27. TRUE
28. FALSE
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29. FALSE
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30. TRUE
31. C
32. B
33. D
34. C
35. B
36. C
37. A
38. B
39. D
40. C
41. A
42. B
43. B
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44. C
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45. D
46. D
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47. D
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48. C
49. B
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50. C
51. B
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52. D
53. C
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54. D
55. C
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56. C
57. D
58. B
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59. B
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60. C
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61. D
62. D
63. C
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64. C
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65. D
66. B
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67. B
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68. B
69. D
70. C
71. C
72. A
73. D
74. C
75. B
76. A
77. D
78. C
79. C
80. A
81. C
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82. D
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83. B
84. C
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85. A
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86. C
87. B
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88. A
89. C
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90. D
91. A
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92. B
93. B
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94. C
95. A
96. C
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97. B
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98. C
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99. D
100. A
101. A
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Writing a put: Min [(stock price - exercise price), 0]

Writing a call: Min [(exercise price - stock price), 0]
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Buying a put: Max [(exercise price - stock price), 0]

102. Buying a call: Max [(stock price - exercise price), 0]
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103. This package protects the investor from downward movement in the stock price. Assuming that the put option was purchased at an exercise
price equal to the current stock price, the maximum loss is the amount of the option premium. However, the investor benefits dollar for dollar
(after recovering premium) from increases in the stock price. This is therefore a defensive strategy.
e. Volatility of stock price – direct relationship; the smaller the likelihood that the stock price could go up, the smaller the potential profit from
holding a call option. Of course, volatility has a downside, but that is the risk that must be borne to have the potential for profit.
d. Time to expiration – direct relationship; since call holders benefit from increases in stock price, it is preferable to have as much time as possible
for the stock price to increase and, in doing so, generate value in the call option.
c. Interest rate – direct relationship; since buying a call option can be considered buying the stock with a deferred payment (when the call is likely
to be exercised), then the higher the interest rate, the lower the present value of funds that must be set aside to cover the exercise price in the
future.
b. Exercise price – inverse relationship; since the holder of a call option benefits directly from increases in stock price, it is preferable to pay as
little as possible up front (exercise price) before the payoff begins.
104. a. Stock price – direct relationship; the holder of a call option benefits as the stock price increases beyond the exercise price. Below the
exercise price, there is no relationship between stock price and call value.
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Price of 4 calls = $50 - $29.27 = $20.73, and price of 1 call = $20.73/4 = $5.18
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105.
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106. When the flexibility is retained in capital budgeting projects to change the scope of the project–whether that means an expansion in the case
of a profitable venture or abandonment in the case of a disastrous venture–then the project has an implicit option value. While there was no explicit
premium paid, the initial cost of the project may have been enlarged to plan in this degree of flexibility; e.g., paying higher supplier prices to
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avoid long-term contracts, or leasing rather than purchasing, etc. In general, the value of the option is the market value that can either be added to
or subtracted from the firm as a result of exercising the option. To clarify the "subtraction" of value from the firm, remember that in the case of
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abandonment, the project NPV is negative and exercising the option just makes it less negative.
107. A warrant offers an option to the bondholder to purchase equity at an agreed price up until some time in the future, which may be a
substantial time period. It's obviously a gamble – if the stock does well, the bondholder benefits and the company has a forced equity issue at a
lower than market price. If the stock never obtains the exercise price of the warrant, then it has no value and the company benefited by issuing
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their debt at a lower yield than otherwise would have been the case. It is somewhat foolish to think that the firm would give away much more than
was necessary to be able to issue their debt. Thus, it is likely that the bondholder has paid fair market value for the warrant. The firm benefits from
lower-cost debt before the warrants are exercised, and pays the cost with potentially diluted earnings per share after the exercise. Of course, if the
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managers of the firm have superior information about the firm's future prospects, the warrants may not be fairly priced.
The bond will sell for the conversion value of $1,085. Assuming that interest rates have not changed, the floor of bond value would be $1,000,
even if stock price declines below $64.52 ($1000 / 15.5 = $64.52).
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108. Conversion Value = 15.5 x 70 = $1,085

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109. A callable bond can be thought of as the combination of a straight bond and a call option that is retained by the issuer of the bonds.
Specifically, the bond can be called prior to its scheduled maturity if the issuer pays the stipulated price, which may include a premium over par
value. This call would likely occur if interest rates had declined substantially, such that the current bonds were selling for a premium and also that
the firm could save enough in future interest expense from refunded debt to more than cover its cost of reissuance. Thus, bondholders will receive
a yield premium over that of straight debt having this rating and maturity. If investors think that their forecast of future interest rates is superior
to that of the market, they may consider this to be an attractive investment. Otherwise, it should perhaps be decided that the bonds will sell at fair
market yield.
Assume price movement to be either $50 or $110 by expiration, then the value of each component will be:
110. If the likelihood of upward or downward prices is equal, then this strategy locks in a profit that is midway between an unprotected loss
(owning the stock in a down market) or an unhindered gain (owning the stock in an up market). From this "midpoint" return must be subtracted the
cost of the two option premiums. So, as long as this midpoint position exceeds the current price of the stock plus the cost of the two premiums, and
assuming that the price is equally likely to move up or down, the investor locks in a gain. The worst-case scenario is when the stock price has no
movement, in which case the investor loses the total of the two option premiums.
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111. Investors who sell calls or puts have unlimited potential for losses, depending on the value the investor must pay to fulfill their obligation.
For example, a premium of $10 could be received to sell a put with strike price of $100. Actually, the potential for loss is not unlimited, but it
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may seem that way as price approaches zero and the put seller must pay $100 for an asset of minimal value. For call sellers, the loss is unlimited.
Imagine receiving $10 in premiums for selling a call with strike price of $100. If stock price rises to $250, the investor has a loss of 127% ($110
inflow, $250 outflow).
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112. Consider options with exercise price of $100. Call the stock price at the expiration date S.
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Immediately exercise the put to sell the share for $30. Riskless profit equals $1.
Buy a share and a put option for a total outlay of: $25 + 4 = $29
On seeing the put options:
As investors rush to pursue this strategy, they will drive up the call price until the profit opportunity disappears.
Riskless profit equals: $25 - ($3 + $20) = $2
Sell the share for $25.
Pay the $20 exercise price.
Exercise the call to purchase stock.
Buy a call option for $3.
113. On seeing the call options:
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The bond is also worth more than the shares it can be converted into. This is because the bond has a ‘floor' value equal to its value as a ‘straight'
6% coupon bond. Even if the stock price declines significantly, the bond will not sell for less than the straight bond value. This extra protection
makes the bond worth more than the shares it can be converted into.
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Therefore, the conversion option is worth: $1,050 - $865.80 = $184.20
[$60 x annuity factor (8%, 10 years)] + $1,000/(1.08)10 = $865.80
114. At an 8 percent yield to maturity, a 10-year, 6 percent coupon bond ordinarily would sell for:
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c. The abandonment option increases NPV by placing a lower bound on the possible payoffs from the project.
c. The exercise price of the option is the price at which it can be sold to the country club. The asset value is the present value of the project if
maintained as a housing development. If this value is less than the value as a golf course, the project will be sold.
115. a. The developer has the option to sell the potential housing development to the country club. This abandonment option is like a put that
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guarantees a minimum payoff from the investment.

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Notice that, if S is between 45 and 65 at option expiration, the total payoff to the portfolio is positive. Otherwise the total payoff is zero. This
portfolio has only nonnegative payoffs. But it has zero cost if the price of the X = 55 call is equal to the average of the prices of the other two calls.
This situation cannot persist. At a cost of zero, all investors will attempt to buy an unlimited amount of this portfolio. We conclude that the price
of the X = 55 call must be less than the average of the prices of the other two calls. In this case, the cost of establishing the portfolio is positive,
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which is consistent with the nonnegative payoffs to the portfolio.

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116.
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f. Decreases
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e. Decreases
d. Increases
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c. Decreases (The present value of the exercise price decreases.)

b. Increases
117. a. Decreases
118. There are two basic types of options. A call option is the right to buy an asset at a specific exercise price on or before the exercise date. A
put is the right to sell an asset at a specific exercise price on or before the exercise date. The payoff to a call is the value of the asset minus the
exercise price if the difference is positive, and zero otherwise. The payoff to a put is the exercise price minus the value of the asset if the difference
is positive, and zero otherwise. The payoff to the seller of an option is the negative of the payoff to the option buyer.
• No matter how far the stock price falls, the owner of the call cannot lose more than the price of the call. On the other hand, the more the stock
price rises above the exercise price, the greater the profit on the call. Therefore, the option holder does not lose from increased variability if things
go wrong, but gains if they go right. The value of the option increases with the variability of stock returns. Of course the longer the time to the
final exercise date, the more opportunity there is for the stock price to vary.
• Investors who buy the stock by way of a call option are buying on installment credit. They pay the purchase price of the option today but they
do not pay the exercise price until they exercise the option. The higher the rate of interest and the longer the time to expiration, the more this "free
credit" is worth.
• To exercise the call option you must pay the exercise price. Other things equal, the less you are obliged to pay, the better. Therefore, the value of
the option is higher when the exercise price is low relative to the stock price.
119. The value of a call option depends on the following considerations:
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120. The importance of building flexibility into investment projects can be reformulated in the language of options. For example, many capital
investments provide the flexibility to expand capacity in the future if demand turns out to be unusually buoyant. They are in effect providing the
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firm with a call option on the extra capacity. Firms also think about alternative uses for their assets if things go wrong. The option to abandon a
project is a put option; the put's exercise price is the value of the project's assets if shifted to an alternative use. The ability to expand or to abandon
are both examples of real options.
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121. Many of the securities that firms issue contain an option. For example, a warrant is nothing but a long-term call option issued by the firm.
Convertible bonds give the investor the option to buy the firm's stock in exchange for the value of the underlying bond. Unlike warrants and
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convertibles, which give an option to the investor, callable bonds give the option to the issuing firm. If interest rates decline and the value of the
underlying bond rises, the firm can buy the bonds back at a specified exercise price.
In 6 months, you would have earned a return of $39.50/$80.50 = .49, or 49%.
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Profit = proceeds - original investment = $120 - $80.50 = $39.50
and the net profit on the call would be
Proceeds = stock price - exercise price = $840 - $720 = $120
122. In December 2007 a call option on Google stock with a June 2008 expiration and an exercise price of $720 sold for $80.50. If you bought this
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call, you gained the right to purchase Google shares for $720 at any time until the option expired in June. The price of Google in December was
$720. If the stock price did not rise by June, the call would not be worth exercising and you would lose your investment of $80.50. On the other
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hand, even a relatively modest rise in the stock price could give you a rich profit on your option. For example, if Google sold for $840 in June, the
proceeds from exercising the call would be:
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23 Summary
Category # of Questions
AACSB: Analytical Skills 18
AACSB: Communication Abilities 8
AACSB: Ethical Understanding & Reasoning Abilities 41
AACSB: Reflective Thinking Skills 55
Blooms: Analysis 18
Blooms: Application 96
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Blooms: Knowledge 8
Brealey - Chapter 023 122
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Difficulty: Easy 57
Difficulty: Hard 3
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Difficulty: Medium 62
Learning Objective: 23-1 115
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23

A. The investor profits when the stock decreases in value.

C. The investor is protected against upside potential.

and the stock was valued at $30 at expiration?

A. $90 per share profit

C. $0 per share profit (break-even)

B. December 1996 expiration, $40 strike price

D. the conversion value of the bond is $900.

per share, then the:

C. bond should trade for $1,100.

A. The firm is in poor financial health.

A. plus the value of the bondholder's call option.

C. plus the value of the issuer's call option.

D. At the point where the graph intercepts the y-axis

strike price of $80? CBA currently trades at $67.

C. When the stock price is approaching zero

B. When the stock is priced far below the strike price

B. When strike price exceeds stock price at expiration

A. less the value of the dividend.

A. options on real assets such as an option to abandon.

D. put options such as held by shareholders of a firm with financial leverage.

A. sell equity without paying flotation costs.

C. reduce the cost of debt by increasing bond prices.

A. debt issuer; stock price

price at expiration of this option is $92, what is your return on investment?

C. greater than $72 but less than $75

D. less than $67 or greater than $83

C. increase the value of the bond

C. stock price minus exercise price

A. buy a stock and write a call option.

C. buy a stock and buy a put option.

106.How, in general, is value derived from options on real assets?

it can be converted into?

119.What are the determinants of option values?

120.What options may be present in capital Investment proposals?

Writing a put: Min [(stock price - exercise price), 0]

Buying a put: Max [(exercise price - stock price), 0]

108. Conversion Value = 15.5 x 70 = $1,085

guarantees a minimum payoff from the investment.

which is consistent with the nonnegative payoffs to the portfolio.

c. Decreases (The present value of the exercise price decreases.)

In 6 months, you would have earned a return of $39.50/$80.50 = .49, or 49%.

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