Test Bank

3324 Words Feb 24th, 2015 14 Pages
CHAPTER 1
Introduction

Practice Questions

Problem 1.8.
Suppose you own 5,000 shares that are worth $25 each. How can put options be used to provide you with insurance against a decline in the value of your holding over the next four months?

You should buy 50 put option contracts (each on 100 shares) with a strike price of $25 and an expiration date in four months. If at the end of four months the stock price proves to be less than $25, you can exercise the options and sell the shares for $25 each.

Problem 1.9.
A stock when it is first issued provides funds for a company. Is the same true of an exchange-traded stock option? Discuss.

An exchange-traded stock option provides no funds for the company. It is a security
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The profit as a function of the stock price is shown in Figure S1.1.

[pic]

Figure S1.1 Profit from long position in Problem 1.13

Problem 1.14.
Suppose that a June put option on a stock with a strike price of $60 costs $4 and is held until June. Under what circumstances will the holder of the option make a gain? Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a short position in the option depends on the stock price at the maturity of the option.

The seller of the option will lose if the price of the stock is below $56.00 in June. (This ignores the time value of money.) The option will be exercised if the price of the stock is below $60.00 in June. The profit as a function of the stock price is shown in Figure S1.2.

[pic]

Figure S1.2 Profit from short position In Problem 1.1

Problem 1.15.
It is May and a trader writes a September call option with a strike price of $20. The stock price is $18, and the option price is $2. Describe the investor’s cash flows if the option is held until September and the stock price is $25 at this time.

The trader has an inflow of $2 in May and an outflow of $5 in September. The $2 is the cash received from the sale of the option. The $5 is the result of the option being exercised. The investor has to buy the stock for $25 in September and sell it to the purchaser of the option for $20.

Problem 1.16.
An investor writes a December put

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