Question

2. Exercise value and option price The value derived from exercising an option immediately is the exercise value. No rational investor would exercise an option that is out-of-the-money, so the minimum exercise value is zero. The following table provides information regarding options on ABC Corp. stock. Because the stock's price is volatile, investors trade options to either hedge their positions or speculate on price movements. Investors can either buy options or "issue" new options, which is called writing options. The following table presents the data on ABC Corp.'s call options at different stock prices. Based on your understanding of exercise value and option prices, complete the table with a strike price of $24.00: Market Price of Option ($) Time Value ($) Exercise Value ($) 0.00 1.56 Stock Price ($) 16.00 32.00 40.00 10.10 2.10 Strike Price ($) 24.00 24.00 24.00 24.00 24.00 2.40 44.00 20.00 18.40 22.60 28.00 48.00 4.00 After two weeks, the stock price of ABC Corp. increases to $52.80. Suppose you purchased the shares for $32.00 and then sell the shares at $52.80; your rate of return will be on that transaction. After your analysis, you decided to purchase the option for $10.10, which gives you the right to buy ABC Corp.'s stock at $24.00. If you exercise the option by purchasing the stock at the strike price, you could immediately sell the share of the stock at its market price of $52.80. This will result in a payoff, and the rate of return on your option will be Answer the following questions, based on your understanding of options, option price, and exercise value. • True or False: An option's price will always be greater than or equal to its exercise value. • True or False: When you buy a put option, you are obliged to sell the underlying asset at the strike price by the expiration date. • True or False: Options can be created and traded without an underlying asset.

Answer 1

Market Price of Call Option = Exercise Value + Time Value

Exercise Value = max((Stock price - Strike Price),0)

1.

1.56 = 0 + Time Value

Time Value = 1.56

2.

10.10 = Exercise Value + 2.10

Exercise Value = 8

3.

18.40 = Exercise Value + 2.40

Exercise Value = 16

4.

22.60 = 20 + Time Value

Time Value = 2.60

5.

28 = Exercise Value + 4

Exercise Value = 24

6.

Rate of Return = ( Selling Price - Purchase Price)/ Purchase Price

Rate of Return = ( 52.80 - 32)/ 32 = 65%

7.

Market Price of Call Option = $10.10

Strike Price = $24

Market Price = $52.80

Payoff = Market Price-Strike Price = 52.80 -24 = $28.80

Rate of Return = (Market Price-(Strike Price+Market Price of Call Option))/(Strike Price+Market Price of Call Option)

Rate of Return = (52.80-24-10.10)/34.10 = 54.83%

8.

True - Option Price = Exercise Price  + Time Value

False - Option does not obliged you to sell

False - Underlying Asset is Required