TBChap 020

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.
B.
C.
D.
I only
II only
III only
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.
B.
C.
D.
I only
II only
I and III only
I, II, and III
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.
B.
C.
D.
I only
II and III only
II only
III only
20-1
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4. An option that can be exercised any time before its expiration date is called:
A.
B.
C.
D.
a European option.
an American option.
a call option.
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.
B.
C.
D.
II and III only

I and II only
I and IV only
III and IV only
6. The owner of a regular exchange-listed call-option on a stock:
A.
B.
C.
D.
has the right to buy 100 shares of the underlying stock at the exercise price.
has the right to sell 100 shares of the underlying stock at the exercise price.
has the obligation to buy 100 shares of the underlying stock at the exercise price.
has the obligation to sell 100 shares of the underlying stock at the exercise price.
7. The owner of a regular exchange-listed put-option on a stock:
A.
B.
C.
D.
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.
B.
C.
D.
I only
II only
III only
II and III only
20-2
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.
B.
C.
D.
I only
II only
III only
II and III only
11. A put option gives the owner the right:
A.
B.
C.
D.
and the obligation to buy an asset at a given price.

and the obligation to sell an asset at a given price.
but not the obligation to buy an asset at a given price.
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.
B.
C.
D.
choice to offset with a put option upon exercise.

obligation to deliver the shares at the exercise price.
choice to deliver shares or take a cash payoff.
obligation to deliver a put option upon exercise.
20-3
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.
B.
C.
D.
15. The writer (seller) of a regular exchange-listed put-option on a stock:
A.
B.
C.
D.
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.
20-4
17. Figure 1 depicts the:
A.
B.
C.
D.
position diagram for the buyer of a call option.

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

20-5
A.
B.
C.
D.
position diagram for the writer (seller) of a call option.

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

20-6
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.
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.
B.
C.
D.
I and II only
III and IV only
III only
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.
B.
C.
D.
buying a call and a put.

buying a put and a share.
buying a put.
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.
20-7
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.
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
28. For European options, the value of a call minus the value of a put is equal to:
A.
B.
C.
D.
the present value of the exercise price minus the value of a share
the present value of the exercise price plus the value of a share
the value of a share plus the present value of the exercise price
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.
B.
C.
D.
I and II only
III and IV only
I and IV only
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.
B.
C.
D.
the value of a put minus the value of a share.

the value of a share minus the value of a call.
the value of a put plus the value of a share.
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.
B.
C.
D.
$3.07
$5.19
$11.43
$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.
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.
B.
C.
D.
I only
II only
III only
I, II, and III
20-10
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.
B.
C.
D.
Lend PV of $100 and buy two calls

Lend PV of $100 and sell two calls
Borrow $100 and buy two calls
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 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.
B.
C.
D.
2
2
( ) (t)
(2)/t
() (t2)
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.
B.
C.
D.
I and II only
II and III only
I and III only
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.
B.
C.
D.
I only
II only
III only
I, II, III, and IV
20-11
44. The value of a call option is negatively related to the:

I) exercise price; II) risk-free rate; III) time to expiration
A.
B.
C.
D.
I only
II only
III only
II and III only
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.
B.
C.
D.
I, II, and III only

II, III, and IV only
I, II, and IV only
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.
B.
C.
D.
I only
II only
I and II only
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.
B.
C.
D.
out of the money.

in the money.
at the money.
cannot be determined.
True / False Questions
20-12
48. A profit diagram implicitly neglects the time value of money.

True
False
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
20-13
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
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.
20-14
66. Explain the difference between a European option and an American option.
67. Define the term call option.
68. Define the term put option.
69. Briefly discuss the usefulness of position diagrams.
20-15
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?
73. Discuss the factors that determine the value of a call option.
20-16
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?
20-17
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.
B.
C.
D.
I only
II only
III only
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.
B.
C.
D.
I only
II only
I and III only
I, II, and III
Type: Medium
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.
B.
C.
D.
I only
II and III only
II only
III only
Type: Easy
20-18
4.
An option that can be exercised any time before its expiration date is called:
A.
B.
C.
D.
a European option.
an American option.
a call option.
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.
B.
C.
D.
II and III only

I and II only
I and IV only
III and IV only
Type: Easy
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:
price.
price.
Type: Medium
20-19
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.
B.
C.
D.
I only
II only
III only
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
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.
B.
C.
D.
I only
II only
III only
II and III only
Type: Easy
20-20
11.
A put option gives the owner the right:
A.
B.
C.
D.
and the obligation to buy an asset at a given price.

and the obligation to sell an asset at a given price.
but not the obligation to buy an asset at a given price.
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.
B.
C.
D.
choice to offset with a put option upon exercise.

obligation to deliver the shares at the exercise price.
choice to deliver shares or take a cash payoff.
obligation to deliver a put option upon exercise.
Type: Difficult
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:
price.
price.
Type: Medium
20-21
15.
The writer (seller) of a regular exchange-listed put-option on a stock:
price.
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
17.
Figure 1 depicts the:
A.
B.
C.
D.

Type: Medium
20-22
18.
A.
B.
C.
D.

Type: Medium
19.
A.
B.
C.
D.

Type: Medium
20-23
20.
A.
B.
C.
D.

Type: Medium
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.
B.
C.
D.
The value of two shares of stock.

The value of one share of stock plus the exercise price.
The exercise price.
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.
B.
C.
D.
I and II only
III and IV only
III only
IV only
Type: Difficult
20-24
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.
B.
C.
D.
buying a call and a put.

buying a put and a share.
buying a put.
selling a call.
Type: Difficult
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.
B.
C.
D.
buying the underlying stock and selling a call.

selling a put and lending the present value of the exercise price.
buying the underlying stock and buying a put.
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
20-25
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
D. that the value of a call option is always twice that of a put given equal exercise
Type: Difficult
28.
For European options, the value of a call minus the value of a put is equal to:
A.
B.
C.
D.
the present value of the exercise price minus the value of a share
the present value of the exercise price plus the value of a share
the value of a share plus the present value of the exercise price
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
20-26
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.
B.
C.
D.
I and II only
III and IV only
I and IV only
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.
B.
C.
D.
the value of a put minus the value of a share.

the value of a share minus the value of a call.
the value of a put plus the value of a share.
the value of a share minus the value of a put.
Type: Difficult
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
20-27
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.
B.
C.
D.
$3.07
$5.19
$11.43
$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.
B.
C.
D.
the put price increases.

the put price decreases.
there is no effect on put price.
the put price can either increase, decrease, or remain the same.
Type: Medium
35.
All else equal, as the underlying stock price increases:
A.
B.
C.
D.
the call price decreases.

the call price increases.
there is no effect on call price.
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
20-28
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.
B.
C.
D.
I only
II only
III only
I, II, and III
Type: Medium
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.
B.
C.
D.
Lend PV of $100 and buy two calls

Lend PV of $100 and sell two calls
Borrow $100 and buy two calls
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
20-29
40.
Relative to the underlying stock, a call option always has:
A.
B.
C.
D.
a higher beta and a higher standard deviation of return.

a lower beta and a higher standard deviation of return.
a higher beta and a lower standard deviation of return.
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 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.
B.
C.
D.
2
2
( ) (t)
(2)/t
2
() (t )
Type: Difficult
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.
B.
C.
D.
I and II only
II and III only
I and III only
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.
B.
C.
D.
I only
II only
III only
I, II, III, and IV
Type: Medium
20-30
44.
The value of a call option is negatively related to the:

I) exercise price; II) risk-free rate; III) time to expiration
A.
B.
C.
D.
I only
II only
III only
II and III only
Type: Medium
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.
B.
C.
D.
I, II, and III only

II, III, and IV only
I, II, and IV only
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.
B.
C.
D.
I only
II only
I and II only
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.
B.
C.
D.
out of the money.

in the money.
at the money.
cannot be determined.
Type: Difficult
20-31
True / False Questions
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
20-32
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
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
20-33
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
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
20-34
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
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 xaxis 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 xaxis 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
20-35
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
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
20-36
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
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 optionto someone
who desires the remaining time value of the optionand realize a higher profit.
Type: Difficult
20-37

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Chapter 20

Multiple Choice Questions

1. Firms regularly use the following to reduce risk:

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

3. An investor, in practice, can buy:

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

II and III only

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

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

11. A put option gives the owner the right:

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

choice to offset with a put option upon exercise.

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

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

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

17. Figure 1 depicts the:

position diagram for the buyer of a call option.

18. Figure 2 depicts the:

position diagram for the buyer of a call option.

19. Figure 3 depicts the:

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

20. Figure 4 depicts the:

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

buying a call and a put.

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

the value of a put minus the value of a share.

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

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

Lend PV of $100 and buy two calls

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

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

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

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

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

I, II, and III only

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

out of the money.

True / False Questions

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

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

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

Short Answer Questions

65. Define the term option.

67. Define the term call option.

68. Define the term put option.

69. Briefly discuss the usefulness of position diagrams.

71. Briefly explain what is meant by protective put.

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

Chapter 20 Understanding Options Answer Key

Multiple Choice Questions

Firms regularly use the following to reduce risk:

The following are examples of "disguised options":

An investor, in practice, can buy:

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

II and III only

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

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

A put option gives the owner the right:

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

choice to offset with a put option upon exercise.

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

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

The value of a put option at expiration equals the: