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Chapter 21
Option Valuation
Multiple Choice Questions
1. Before expiration, the time value of an in the money call option is always
A. equal to zero.
B. positive.
C. negative.
D. equal to the stock price minus the exercise price.
E. None of these is correct.
2. Before expiration, the time value of an in the money put option is always
A. equal to zero.
B. negative.
C. positive.
D. equal to the stock price minus the exercise price.
E. None of these is correct.
3. Before expiration, the time value of an at the money call option is always
A. positive.
B. equal to zero.
C. negative.
D. equal to the stock price minus the exercise price.
E. None of these is correct.
4. Before expiration, the time value of an at the money put option is always
A. equal to zero.
B. equal to the stock price minus the exercise price.
C. negative.
D. positive.
E. None of these is correct.
21-1
21-2
13. If the stock price increases, the price of a put option on that stock __________ and that of
a call option __________.
A. decreases; increases
B. decreases; decreases
C. increases; decreases
D. increases; increases
E. does not change; does not change
21-3
14. If the stock price decreases, the price of a put option on that stock __________ and that of
a call option __________.
A. decreases; increases
B. decreases; decreases
C. increases; decreases
D. increases; increases
E. does not change; does not change
15. Other things equal, the price of a stock call option is positively correlated with the
following factors except
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. None of these is correct.
16. Other things equal, the price of a stock call option is positively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. the stock price, the time to expiration, and the stock volatility.
17. Other things equal, the price of a stock call option is negatively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. the stock price, the time to expiration, and the stock volatility.
21-4
18. Other things equal, the price of a stock put option is positively correlated with the
following factors except
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. None of these is correct.
19. Other things equal, the price of a stock put option is positively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. the time to expiration, the stock volatility, and the exercise price.
20. Other things equal, the price of a stock put option is negatively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. the time to expiration, the stock volatility, and the exercise price.
21. The price of a stock put option is __________ correlated with the stock price and
__________ correlated with the striking price.
A. positively; positively
B. negatively; positively
C. negatively; negatively
D. positively; negatively
E. not; not
21-5
22. The price of a stock call option is __________ correlated with the stock price and
__________ correlated with the striking price.
A. positively; positively
B. negatively; positively
C. negatively; negatively
D. positively; negatively
E. not; not
23. All the inputs in the Black-Scholes Option Pricing Model are directly observable except
A. the price of the underlying security.
B. the risk free rate of interest.
C. the time to expiration.
D. the variance of returns of the underlying asset return.
E. None of these is correct.
24. Which of the inputs in the Black-Scholes Option Pricing Model are directly observable
A. the price of the underlying security.
B. the risk free rate of interest.
C. the time to expiration.
D. the variance of returns of the underlying asset return.
E. the price of the underlying security, the risk free rate of interest, and the time to expiration.
21-6
26. A hedge ratio of 0.70 implies that a hedged portfolio should consist of
A. long 0.70 calls for each short stock.
B. short 0.70 calls for each long stock.
C. long 0.70 shares for each short call.
D. long 0.70 shares for each long call.
E. None of these is correct.
27. A hedge ratio of 0.85 implies that a hedged portfolio should consist of
A. long 0.85 calls for each short stock.
B. short 0.85 calls for each long stock.
C. long 0.85 shares for each short call.
D. long 0.85 shares for each long call.
E. None of these is correct.
28. A hedge ratio for a call option is ________ and a hedge ratio for a put option is ______.
A. negative; positive
B. negative; negative
C. positive; negative
D. positive; positive
E. zero; zero
21-7
31. The dollar change in the value of a stock call option is always
A. lower than the dollar change in the value of the stock.
B. higher than the dollar change in the value of the stock.
C. negatively correlated with the change in the value of the stock.
D. higher than the dollar change in the value of the stock and negatively correlated with the
change in the value of the stock.
E. lower than the dollar change in the value of the stock and negatively correlated with the
change in the value of the stock.
32. The percentage change in the stock call option price divided by the percentage change in
the stock price is called
A. the elasticity of the option.
B. the delta of the option.
C. the theta of the option.
D. the gamma of the option.
E. None of these is correct.
21-8
21-9
40. Portfolio A consists of 150 shares of stock and 300 calls on that stock. Portfolio B consists
of 575 shares of stock. The call delta is 0.7. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B.
B. Portfolio A.
C. The two portfolios have the same exposure.
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
41. Portfolio A consists of 500 shares of stock and 500 calls on that stock. Portfolio B consists
of 800 shares of stock. The call delta is 0.6. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B.
B. Portfolio A.
C. The two portfolios have the same exposure.
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
42. Portfolio A consists of 400 shares of stock and 400 calls on that stock. Portfolio B consists
of 500 shares of stock. The call delta is 0.5. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B.
B. Portfolio A.
C. The two portfolios have the same exposure.
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
21-10
43. Portfolio A consists of 600 shares of stock and 300 calls on that stock. Portfolio B consists
of 685 shares of stock. The call delta is 0.3. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B.
B. Portfolio A.
C. The two portfolios have the same exposure.
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
44. A portfolio consists of 100 shares of stock and 1500 calls on that stock. If the hedge ratio
for the call is 0.7, what would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. +$700
B. +$500
C. $1,150
D. $520
E. None of these is correct.
45. A portfolio consists of 800 shares of stock and 100 calls on that stock. If the hedge ratio
for the call is 0.5. What would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. +$700
B. $850
C. $580
D. $520
E. None of these is correct.
46. A portfolio consists of 225 shares of stock and 300 calls on that stock. If the hedge ratio
for the call is 0.4, what would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. -$345
B. +$500
C. $580
D. $520
E. None of these is correct.
21-11
47. A portfolio consists of 400 shares of stock and 200 calls on that stock. If the hedge ratio
for the call is 0.6, what would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. +$700
B. +$500
C. $580
D. $520
E. None of these is correct.
48. If the hedge ratio for a stock call is 0.30, the hedge ratio for a put with the same expiration
date and exercise price as the call would be ________.
A. 0.70
B. 0.30
C. 0.70
D. 0.30
E. 0.17
49. If the hedge ratio for a stock call is 0.50, the hedge ratio for a put with the same expiration
date and exercise price as the call would be ________.
A. 0.30
B. 0.50
C. 0.60
D. 0.50
E. 0.17
50. If the hedge ratio for a stock call is 0.60, the hedge ratio for a put with the same expiration
date and exercise price as the call would be _______.
A. 0.60
B. 0.40
C. 0.60
D. 0.40
E. 0.17
21-12
51. If the hedge ratio for a stock call is 0.70, the hedge ratio for a put with the same expiration
date and exercise price as the call would be _______.
A. 0.70
B. 0.30
C. 0.70
D. 0.30
E. 0.17
52. A put option is currently selling for $6 with an exercise price of $50. If the hedge ratio for
the put is -0.30 and the stock is currently selling for $46, what is the elasticity of the put?
A. 2.76
B. 2.30
C. 7.67
D. 2.76
E. 2.30
53. A put option on the S&P 500 index will best protect ________
A. a portfolio of 100 shares of IBM stock.
B. a portfolio of 50 bonds.
C. a portfolio that corresponds to the S&P 500.
D. a portfolio of 50 shares of AT&T and 50 shares of Xerox stocks.
E. a portfolio that replicates the Dow.
54. Higher dividend payout policies have a __________ impact on the value of the call and a
__________ impact on the value of the put compared to lower dividend payout policies.
A. negative; negative
B. positive; positive
C. positive; negative
D. negative; positive
E. zero; zero
21-13
55. Lower dividend payout policies have a __________ impact on the value of the call and a
__________ impact on the value of the put compared to higher dividend payout policies.
A. negative; negative
B. positive; positive
C. positive; negative
D. negative; positive
E. zero; zero
56. A one dollar decrease in a call option's exercise price would result in a(n) __________ in
the call option's value of __________ one dollar.
A. increase; more than
B. decrease; more than
C. decrease; less than
D. increase; less than
E. increase; exactly
57. Which one of the following variables influence the value of call options?
I) Level of interest rates.
II) Time to expiration of the option.
III) Dividend yield of underlying stock.
IV) Stock price volatility.
A. I and IV only.
B. II and III only.
C. I, II, and IV only.
D. I, II, III, and IV.
E. I, II, and III only.
21-14
58. Which one of the following variables influence the value of put options?
I) Level of interest rates.
II) Time to expiration of the option.
III) Dividend yield of underlying stock.
IV) Stock price volatility.
A. I and IV only.
B. II and III only.
C. I, II, and IV only.
D. I, II, III, and IV.
E. I, II, and III only.
61. Use the two-state put option value in this problem. SO= $100; X = $120; the two
possibilities for STare $150 and $80. The range of P across the two states is _____; the hedge
ratio is _______.
A. $0 and $40; 4/7
B. $0 and $50; +4/7
C. $0 and $40; +4/7
D. $0 and $50; 4/7
E. $20 and $40; +1/2
21-15
62. Use the Black-Scholes Option Pricing Model for the following problem. Given: SO= $70;
X = $70; T = 70 days; r = 0.06 annually (0.0001648 daily); = 0.020506 (daily). No
dividends will be paid before option expires. The value of the call option is _______.
A. $10.16
B. $5.16
C. $0.00
D. $2.16
E. None of these is correct.
An American-style call option with six months to maturity has a strike price of $35. The
underlying stock now sells for $43. The call premium is $12.
21-16
68. If the company unexpectedly announces it will pay its first-ever dividend 3 months from
today, you would expect that
A. the call price would increase.
B. the call price would decrease.
C. the call price would not change.
D. the put price would decrease.
E. the put price would not change.
21-17
70. Since deltas change as stock values change, portfolio hedge ratios must be constantly
updated in active markets. This process is referred to as
A. portfolio insurance.
B. rebalancing.
C. option elasticity.
D. gamma hedging.
E. dynamic hedging.
72. Rubinstein (1994) observed that the performance of the Black-Scholes model had
deteriorated in recent years, and he attributed this to
A. investor fears of another market crash.
B. higher than normal dividend payouts.
C. early exercise of American call options.
D. decreases in transaction costs.
E. None of these is correct.
21-18
21-19
76. As the underlying stock's price increased, the call option valuation function's slope
approaches
A. zero.
B. one.
C. two times the value of the stock.
D. one-half times the value of the stock.
E. infinity.
21-20
80. The hedge ratio of an option is also called the options _______.
A. alpha
B. beta
C. sigma
D. delta
E. rho
21-21
84. If the company unexpectedly announces it will pay its first-ever dividend 4 months from
today, you would expect that
Refer To: 21-82
A. the call price would increase.
B. the call price would decrease.
C. the call price would not change.
D. the put price would decrease.
E. the put price would not change.
87. Discuss the relationship between option prices and time to expiration, volatility of the
underlying stocks, and the exercise price.
21-22
88. Which of the variables affecting option pricing is not directly observable? If this variable
is estimated to be higher or lower than the variable actually is how is the option valuation
affected?
89. What is an option hedge ratio? How does the hedge ratio for a call differ from that of a put
(or are the two equivalent)? Explain.
21-23
90. You are evaluating a stock that is currently selling for $30 per share. Over the investment
period you think that the stock price might get as low as $25 or as high as $40. There is a call
option available on the stock with an exercise price of $35. Answer the following questions
about hedging your position in the stock. Assume that you will hold one share.
What is the hedge ratio?
How much would you borrow to purchase the stock?
What is the amount of your net investment in the stock?
Complete the table below to show the value of your stock portfolio at the end of the holding
period.
How many call options will you combine with the stock to construct the perfect hedge? Will
you buy the calls or sell the calls?
Show the option values in the table below.
21-24
1. Before expiration, the time value of an in the money call option is always
A. equal to zero.
B. positive.
C. negative.
D. equal to the stock price minus the exercise price.
E. None of these is correct.
The difference between the actual option price and the intrinsic value is called the time value
of the option. Time value is always positive before expiration.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
2. Before expiration, the time value of an in the money put option is always
A. equal to zero.
B. negative.
C. positive.
D. equal to the stock price minus the exercise price.
E. None of these is correct.
The difference between the actual option price and the intrinsic value is called the time value
of the option. Time value is always positive before expiration.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
21-25
3. Before expiration, the time value of an at the money call option is always
A. positive.
B. equal to zero.
C. negative.
D. equal to the stock price minus the exercise price.
E. None of these is correct.
The difference between the actual option price and the intrinsic value is called the time value
of the option. Time value is always positive before expiration.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
4. Before expiration, the time value of an at the money put option is always
A. equal to zero.
B. equal to the stock price minus the exercise price.
C. negative.
D. positive.
E. None of these is correct.
The difference between the actual option price and the intrinsic value is called the time value
of the option. Time value is always positive before expiration.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
21-26
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
21-27
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
21-28
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
21-29
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-30
13. If the stock price increases, the price of a put option on that stock __________ and that of
a call option __________.
A. decreases, increases
B. decreases, decreases
C. increases, decreases
D. increases, increases
E. does not change, does not change
As stock prices increase, call options become more valuable (the owner can buy the stock at a
bargain price). As stock prices increase, put options become less valuable (the owner can sell
the stock at a price less than market price).
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
14. If the stock price decreases, the price of a put option on that stock __________ and that of
a call option __________.
A. decreases, increases
B. decreases, decreases
C. increases, decreases
D. increases, increases
E. does not change, does not change
As stock prices decrease, call options become less valuable (the owner cannot buy the stock at
a bargain price). As stock prices decrease, put options become more valuable (the owner can
sell the stock at a price greater than market price).
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Option valuation
21-31
15. Other things equal, the price of a stock call option is positively correlated with the
following factors except
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. None of these is correct.
The exercise price is negatively correlated with the call option price.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
16. Other things equal, the price of a stock call option is positively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. the stock price, the time to expiration, and the stock volatility.
The exercise price is negatively correlated with the call option price.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-32
17. Other things equal, the price of a stock call option is negatively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. the stock price, the time to expiration, and the stock volatility.
The exercise price is negatively correlated with the call option price.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
18. Other things equal, the price of a stock put option is positively correlated with the
following factors except
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. None of these is correct.
The put option price is negatively correlated with the stock price.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-33
19. Other things equal, the price of a stock put option is positively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. the time to expiration, the stock volatility, and the exercise price.
The put option price is negatively correlated with the stock price.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
20. Other things equal, the price of a stock put option is negatively correlated with the
following factors
A. the stock price.
B. the time to expiration.
C. the stock volatility.
D. the exercise price.
E. the time to expiration, the stock volatility, and the exercise price.
The exercise price is negatively correlated with the stock price.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-34
21. The price of a stock put option is __________ correlated with the stock price and
__________ correlated with the striking price.
A. positively, positively
B. negatively, positively
C. negatively, negatively
D. positively, negatively
E. not, not
The lower the stock price, the more valuable the put option. The higher the striking price, the
more valuable the put option.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
22. The price of a stock call option is __________ correlated with the stock price and
__________ correlated with the striking price.
A. positively, positively
B. negatively, positively
C. negatively, negatively
D. positively, negatively
E. not, not
The higher the stock price, the more valuable the call option. The lower the striking price, the
more valuable the call option.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-35
23. All the inputs in the Black-Scholes Option Pricing Model are directly observable except
A. the price of the underlying security.
B. the risk free rate of interest.
C. the time to expiration.
D. the variance of returns of the underlying asset return.
E. None of these is correct.
The variance of the returns of the underlying asset is not directly observable, but must be
estimated from historical data, from scenario analysis, or from the prices of other options.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
24. Which of the inputs in the Black-Scholes Option Pricing Model are directly observable
A. the price of the underlying security.
B. the risk free rate of interest.
C. the time to expiration.
D. the variance of returns of the underlying asset return.
E. the price of the underlying security, the risk free rate of interest, and the time to expiration.
The variance of the returns of the underlying asset is not directly observable, but must be
estimated from historical data, from scenario analysis, or from the prices of other options.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-36
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
26. A hedge ratio of 0.70 implies that a hedged portfolio should consist of
A. long 0.70 calls for each short stock.
B. short 0.70 calls for each long stock.
C. long 0.70 shares for each short call.
D. long 0.70 shares for each long call.
E. None of these is correct.
The hedge ratio is the slope of the option value as a function of the stock value. A slope of
0.70 means that as the stock increases in value by $1, the option increases by approximately
$0.70. Thus, for every call written, 0.70 shares of stock would be needed to hedge the
investor's portfolio.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-37
27. A hedge ratio of 0.85 implies that a hedged portfolio should consist of
A. long 0.85 calls for each short stock.
B. short 0.85 calls for each long stock.
C. long 0.85 shares for each short call.
D. long 0.85 shares for each long call.
E. None of these is correct.
The hedge ratio is the slope of the option value as a function of the stock value. A slope of
0.85 means that as the stock increases in value by $1, the option increases by approximately
$0.85. Thus, for every call written, 0.85 shares of stock would be needed to hedge the
investor's portfolio.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
28. A hedge ratio for a call option is ________ and a hedge ratio for a put option is ______.
A. negative, positive
B. negative, negative
C. positive, negative
D. positive, positive
E. zero, zero
Call option hedge ratios must be positive and less than 1.0, and put option ratios must be
negative, with a smaller absolute value than 1.0.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-38
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-39
31. The dollar change in the value of a stock call option is always
A. lower than the dollar change in the value of the stock.
B. higher than the dollar change in the value of the stock.
C. negatively correlated with the change in the value of the stock.
D. higher than the dollar change in the value of the stock and negatively correlated with the
change in the value of the stock.
E. lower than the dollar change in the value of the stock and negatively correlated with the
change in the value of the stock.
The slope of the call option valuation function is less than one.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
32. The percentage change in the stock call option price divided by the percentage change in
the stock price is called
A. the elasticity of the option.
B. the delta of the option.
C. the theta of the option.
D. the gamma of the option.
E. None of these is correct.
Option price elasticity measures the percent change in the option price as a function of the
percent change in the stock price.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-40
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-41
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-42
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-43
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
40. Portfolio A consists of 150 shares of stock and 300 calls on that stock. Portfolio B consists
of 575 shares of stock. The call delta is 0.7. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B.
B. Portfolio A.
C. The two portfolios have the same exposure.
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
300 calls (0.7) = 210 shares + 150 shares = 360 shares; 575 shares = 575 shares.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
21-44
41. Portfolio A consists of 500 shares of stock and 500 calls on that stock. Portfolio B consists
of 800 shares of stock. The call delta is 0.6. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B.
B. Portfolio A.
C. The two portfolios have the same exposure.
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
500 calls (0.6) = 300 shares + 500 shares = 800 shares; 800 shares = 800 shares.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
42. Portfolio A consists of 400 shares of stock and 400 calls on that stock. Portfolio B consists
of 500 shares of stock. The call delta is 0.5. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B.
B. Portfolio A.
C. The two portfolios have the same exposure.
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
400 calls (0.5) = 200 shares + 400 shares = 600 shares; 500 shares = 500 shares.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
21-45
43. Portfolio A consists of 600 shares of stock and 300 calls on that stock. Portfolio B consists
of 685 shares of stock. The call delta is 0.3. Which portfolio has a higher dollar exposure to a
change in stock price?
A. Portfolio B.
B. Portfolio A.
C. The two portfolios have the same exposure.
D. A if the stock price increases and B if it decreases.
E. B if the stock price decreases and A if it increases.
300 calls (0.3) = 90 shares + 600 shares = 690 shares; 685 shares = 685 shares.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
44. A portfolio consists of 100 shares of stock and 1500 calls on that stock. If the hedge ratio
for the call is 0.7, what would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. +$700
B. +$500
C. -$1,150
D. -$520
E. None of these is correct
$100 + [$1,500(0.7)] = $1,150.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
21-46
45. A portfolio consists of 800 shares of stock and 100 calls on that stock. If the hedge ratio
for the call is 0.5. What would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. +$700
B. -$850
C. -$580
D. -$520
E. None of these is correct
$800 + [$100(0.5)] = $850.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
46. A portfolio consists of 225 shares of stock and 300 calls on that stock. If the hedge ratio
for the call is 0.4, what would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. -$345
B. +$500
C. -$580
D. -$520
E. None of these is correct
$225 + [$300(0.4)] = $345.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
21-47
47. A portfolio consists of 400 shares of stock and 200 calls on that stock. If the hedge ratio
for the call is 0.6, what would be the dollar change in the value of the portfolio in response to
a one dollar decline in the stock price?
A. +$700
B. +$500
C. -$580
D. -$520
E. None of these is correct
$400 + [$200(0.6)] = $520.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
48. If the hedge ratio for a stock call is 0.30, the hedge ratio for a put with the same expiration
date and exercise price as the call would be ________.
A. 0.70
B. 0.30
C. -0.70
D. -0.30
E. -.17
Call hedge ratio = N(d1); Put hedge ratio = N(d1) 1; 0.3 1.0 = 0.7.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
21-48
49. If the hedge ratio for a stock call is 0.50, the hedge ratio for a put with the same expiration
date and exercise price as the call would be ________.
A. 0.30
B. 0.50
C. -0.60
D. -0.50
E. -.17
Call hedge ratio = N(d1); Put hedge ratio = N(d1) 1; 0.5 1.0 = 0.5.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
50. If the hedge ratio for a stock call is 0.60, the hedge ratio for a put with the same expiration
date and exercise price as the call would be _______.
A. 0.60
B. 0.40
C. -0.60
D. -0.40
E. -.17
Call hedge ratio = N(d1); Put hedge ratio = N(d1) 1; 0.6 1.0 = 0.4.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
21-49
51. If the hedge ratio for a stock call is 0.70, the hedge ratio for a put with the same expiration
date and exercise price as the call would be _______.
A. 0.70
B. 0.30
C. -0.70
D. -0.30
E. -.17
Call hedge ratio = N(d1); Put hedge ratio = N(d1) 1; 0.7 1.0 = 0.3.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
52. A put option is currently selling for $6 with an exercise price of $50. If the hedge ratio for
the put is 0.30 and the stock is currently selling for $46, what is the elasticity of the put?
A. 2.76
B. 2.30
C. -7.67
D. -2.76
E. -2.30
% stock price change = ($47 $46)/$46 = 0.021739; % option price change = ($5.70
$6.00)/$6 = 0.05; 0.05/0.021739 = 2.30.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
21-50
53. A put option on the S&P 500 index will best protect ________
A. a portfolio of 100 shares of IBM stock.
B. a portfolio of 50 bonds.
C. a portfolio that corresponds to the S&P 500.
D. a portfolio of 50 shares of AT&T and 50 shares of Xerox stocks.
E. a portfolio that replicates the Dow.
The S&P 500 index is more like a portfolio that corresponds to the S&P 500 and thus is more
protective of such a portfolio than of any of the other assets.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic
Topic: Option valuation
54. Higher dividend payout policies have a __________ impact on the value of the call and a
__________ impact on the value of the put compared to lower dividend payout policies.
A. negative, negative
B. positive, positive
C. positive, negative
D. negative, positive
E. zero, zero
Dividends lower the expected stock price, and thus lower the current call option value and
increase the current put option value.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Option valuation
21-51
55. Lower dividend payout policies have a __________ impact on the value of the call and a
__________ impact on the value of the put compared to higher dividend payout policies.
A. negative, negative
B. positive, positive
C. positive, negative
D. negative, positive
E. zero, zero
Dividends lower the expected stock price, and thus lower the current call option value and
increase the current put option value.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Option valuation
56. A one dollar decrease in a call option's exercise price would result in a(n) __________ in
the call option's value of __________ one dollar.
A. increase, more than
B. decrease, more than
C. decrease, less than
D. increase, less than
E. increase, exactly
Option prices are less than stock prices, thus changes in stock prices (market or exercise) are
greater (in absolute terms) than are changes in prices of options.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Option valuation
21-52
57. Which one of the following variables influence the value of call options?
I) Level of interest rates.
II) Time to expiration of the option.
III) Dividend yield of underlying stock.
IV) Stock price volatility.
A. I and IV only.
B. II and III only.
C. I, II, and IV only.
D. I, II, III, and IV.
E. I, II and III only.
All of the these variables affect call option prices.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
58. Which one of the following variables influence the value of put options?
I) Level of interest rates.
II) Time to expiration of the option.
III) Dividend yield of underlying stock.
IV) Stock price volatility.
A. I and IV only.
B. II and III only.
C. I, II, and IV only.
D. I, II, III, and IV.
E. I, II and III only.
All of these variables affect put option prices.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-53
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-54
61. Use the two-state put option value in this problem. SO= $100; X = $120; the two
possibilities for STare $150 and $80. The range of P across the two states is _____; the hedge
ratio is _______.
A. $0 and $40; -4/7
B. $0 and $50; +4/7
C. $0 and $40; +4/7
D. $0 and $50; -4/7
E. $20 and $40; +1/2
When ST = $150; P = $0; when ST =$80: P = $40; ($0 $40)/($150 $80) = 4/7.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
62. Use the Black-Scholes Option Pricing Model for the following problem. Given: SO= $70;
X = $70; T = 70 days; r = 0.06 annually (0.0001648 daily); = 0.020506 (daily). No
dividends will be paid before option expires. The value of the call option is _______.
A. $10.16
B. $5.16
C. $0.00
D. $2.16
E. None of these is correct
d2 = 0.1530277 (0.020506)(70)1/2 = 0.01853781; N(d1) = 0.5600; N(d2) = 0.4919; C =
0.5600($70) $70[e-(0.0001648)(70)]0.4919 = $5.16.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
21-55
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Option valuation
An American-style call option with six months to maturity has a strike price of $35. The
underlying stock now sells for $43. The call premium is $12.
21-56
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic
Topic: Option valuation
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Option valuation
21-57
68. If the company unexpectedly announces it will pay its first-ever dividend 3 months from
today, you would expect that
A. the call price would increase.
B. the call price would decrease.
C. the call price would not change.
D. the put price would decrease.
E. the put price would not change.
As an approximation, subtract the present value of the dividend from the stock price and
recompute the Black-Scholes value with this adjusted stock price. Since the stock price is
lower, the option value will be lower.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
Topic: Option valuation
21-58
70. Since deltas change as stock values change, portfolio hedge ratios must be constantly
updated in active markets. This process is referred to as
A. portfolio insurance.
B. rebalancing.
C. option elasticity.
D. gamma hedging.
E. dynamic hedging.
Dynamic hedgers will convert equity into cash in market declines to adjust for changes in
option deltas.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
Topic: Option valuation
21-59
72. Rubinstein (1994) observed that the performance of the Black-Scholes model had
deteriorated in recent years, and he attributed this to
A. investor fears of another market crash.
B. higher than normal dividend payouts.
C. early exercise of American call options.
D. decreases in transaction costs.
E. None of these is correct.
Options on the same stock with the same strike price should have the same implied volatility,
but they exhibit progressively different implied volatilities. Rubinstein believes this is due to
fear of another market crash.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
21-60
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
21-61
76. As the underlying stock's price increased, the call option valuation function's slope
approaches
A. zero.
B. one.
C. two times the value of the stock.
D. one-half times the value of the stock.
E. infinity.
As the stock price increases the value of the call option increases in price one for one with the
stock price. The option is very likely to be exercised.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
21-62
AACSB: Analytic
Bloom's: Remember
Difficulty: Challenge
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-63
80. The hedge ratio of an option is also called the options _______.
A. alpha
B. beta
C. sigma
D. delta
E. rho
The two terms mean the same thing.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-64
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic
Topic: Option valuation
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Option valuation
21-65
84. If the company unexpectedly announces it will pay its first-ever dividend 4 months from
today, you would expect that
Refer To: 21-82
A. the call price would increase.
B. the call price would decrease.
C. the call price would not change.
D. the put price would decrease.
E. the put price would not change.
As an approximation, subtract the present value of the dividend from the stock price and
recompute the Black-Scholes value with this adjusted stock price. Since the stock price is
lower, the option value will be lower.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Option valuation
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
21-66
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Option valuation
87. Discuss the relationship between option prices and time to expiration, volatility of the
underlying stocks, and the exercise price.
The longer the time to expiration, the higher the premium because it is more likely that an
option will become more valuable (more time for the stock price to change). The greater the
volatility of the underlying stock, the greater the option premium; the more volatile the stock,
the more likely it is that the option will become more valuable (e. g., move from an out of the
money to an in the money option, or become more in the money). For call options, the lower
the exercise price, the more valuable the option, as the option owner can buy the stock at a
lower price. For a put option, the lower the exercise price, the less valuable the option, as the
owner of the option may be required to sell the stock at a lower than market price.
Feedback: The purpose of this question is to ensure that the student understands the
relationships of the variables that determine option prices, and the differences and similarities
of these variables on put and call option prices.
21-67
88. Which of the variables affecting option pricing is not directly observable? If this variable
is estimated to be higher or lower than the variable actually is how is the option valuation
affected?
The volatility of the underlying stock is not directly observable, but can be estimated from
historic data. If the implied volatility is lower than the actual volatility of the stock, the option
will be undervalued, as the higher the implied volatility, the higher the price of the option.
Investors often use the implied volatility of the stock, i.e., the volatility of the stock implied
by the price of the option. If investors think the actual volatility of the stock exceeds the
implied volatility, the option would be considered to be underpriced. If actual volatility
appears to be higher than the implied volatility, the "fair price" of the option would exceed the
actual price.
Feedback: The purpose of this question is to determine whether the student understands how
some investors use option pricing based on implied volatility to determine if the option
appears to be over or undervalued.
89. What is an option hedge ratio? How does the hedge ratio for a call differ from that of a put
(or are the two equivalent)? Explain.
An option's hedge ratio is the change in the price of an option for a $1 increase in the stock
price. A call option has a positive hedge ratio; a put option has a negative hedge ratio. The
hedge ratio is the slope of the value function of the option evaluated at the current stock price.
Feedback: The purpose of this question is to determine whether the student understands hedge
ratios and how these ratios vary for puts and calls.
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90. You are evaluating a stock that is currently selling for $30 per share. Over the investment
period you think that the stock price might get as low as $25 or as high as $40. There is a call
option available on the stock with an exercise price of $35. Answer the following questions
about hedging your position in the stock. Assume that you will hold one share.
What is the hedge ratio?
How much would you borrow to purchase the stock?
What is the amount of your net investment in the stock?
Complete the table below to show the value of your stock portfolio at the end of the holding
period.
How many call options will you combine with the stock to construct the perfect hedge? Will
you buy the calls or sell the calls?
Show the option values in the table below.
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How many call options will you combine with the stock to construct the perfect hedge? Will
you buy the calls or sell the calls? Since the hedge ratio is 1/3 buy one stock and sell three call
options.
Show the option values in the table below.
What must the price of one call option be? The value of the stock portfolio equals the value of
three calls. The net investment in the stock portfolio is $6.42 so this must equal the value of
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the three calls. $6.42 = 3C, and C = $2.14. Alternatively, the value of the whole position must
21-71
equal the present value of the certain payoff: S 3C = $23.58, $30 3C = $23.58, and C =
$2.14.
Feedback: This question tests the student's ability to construct a perfect hedge on a stock
portfolio using call options.
21-72