Chapter 14 Options and Corporate Finance
CHAPTER 14
OPTIONS AND CORPORATE FINANCE
Answers to Concepts Review and Critical Thinking Questions
1. A call option confers the right, without the obligation, to buy an asset at a given price on or before a given date. A put option confers the right, without the obligation, to sell an asset at a given price on or before a given date. You would buy a call option if you expect the price of the asset to increase. You would buy a put option if you expect the price of the asset to decrease. A call option has unlimited potential profit, while a put option has limited potential profit; the underlying asset’s price cannot be less than zero.
2. a. The buyer of a call option pays money for the right to buy.... b. The buyer of a put option pays money for the right to sell.... c. The seller of a call option receives money for the obligation to sell.... d. The seller of a put option receives money for the obligation to buy....
3. The intrinsic value of a call option is Max [S – E,0]. It is the value of the option at expiration.
4. The value of a put option at expiration is Max[E – S,0]. By definition, the intrinsic value of an option is its value at expiration, so Max[E – S,0] is the intrinsic value of a put option.
5. The call is selling for less than its intrinsic value; an arbitrage opportunity exists. Buy the call for $10, exercise the call by paying $35 in return for a share of stock, and sell the stock for $50. You’ve made a riskless $5 profit.
6. The prices of both the call and the put option should increase. The higher level of downside risk still results in an option price of zero, but the upside potential is greater since there is a higher probability that the asset will finish in the money.
7. False. The value of a call option depends on the total variance of the underlying asset, not just the systematic variance.
8. The call option will sell for more since it provides an unlimited profit opportunity, while the
OPTIONS AND CORPORATE FINANCE
Answers to Concepts Review and Critical Thinking Questions
1. A call option confers the right, without the obligation, to buy an asset at a given price on or before a given date. A put option confers the right, without the obligation, to sell an asset at a given price on or before a given date. You would buy a call option if you expect the price of the asset to increase. You would buy a put option if you expect the price of the asset to decrease. A call option has unlimited potential profit, while a put option has limited potential profit; the underlying asset’s price cannot be less than zero.
2. a. The buyer of a call option pays money for the right to buy.... b. The buyer of a put option pays money for the right to sell.... c. The seller of a call option receives money for the obligation to sell.... d. The seller of a put option receives money for the obligation to buy....
3. The intrinsic value of a call option is Max [S – E,0]. It is the value of the option at expiration.
4. The value of a put option at expiration is Max[E – S,0]. By definition, the intrinsic value of an option is its value at expiration, so Max[E – S,0] is the intrinsic value of a put option.
5. The call is selling for less than its intrinsic value; an arbitrage opportunity exists. Buy the call for $10, exercise the call by paying $35 in return for a share of stock, and sell the stock for $50. You’ve made a riskless $5 profit.
6. The prices of both the call and the put option should increase. The higher level of downside risk still results in an option price of zero, but the upside potential is greater since there is a higher probability that the asset will finish in the money.
7. False. The value of a call option depends on the total variance of the underlying asset, not just the systematic variance.
8. The call option will sell for more since it provides an unlimited profit opportunity, while the