BRIGHAM CH 19 SM 3ce - REVISED
BRIGHAM CH 19 SM 3ce - REVISED
BRIGHAM CH 19 SM 3ce - REVISED
ASSIGNED QUESTIONS:
PROBLEMS:
19-1, 19-3, 19-4,
19-1 a. An option is a contract that gives its holder the right to buy or sell an asset at some
predetermined price within a specified period of time. A call option allows the holder
to buy the asset, while a put option allows the holder to sell the asset.
b. A simple measure of an option’s value is its exercise value. The exercise value is
equal to the current price of the stock (underlying the option) less the striking price of
the option. The strike price is the price stated in the option contract at which the
security can be bought (or sold). For example, if the underlying stock sells for $50
and the striking price is $20, the exercise value of the option would be $30.
c. The Black-Scholes Option Pricing Model is widely used by option traders to value
options. It is derived from the concept of a riskless hedge. By buying shares of a stock
and simultaneously selling call options on that stock, the investor will create a risk-
free investment position. This riskless return must equal the risk-free rate or an
arbitrage opportunity would exist. People would take advantage of this opportunity
until the equilibrium level estimated by the Black-Scholes model was reached.
19-2 The market value of an option is typically higher than its exercise value due to the
speculative nature of the investment. Options allow investors to gain a high degree of
personal leverage when buying securities. The option allows the investor to limit his or
her loss but amplify his or her return. The exact amount this protection is worth is the
options time value, which is the difference between the option’s price and its exercise
value.
19-3 (1) An increase in stock price causes an increase in the value of a call option. (2) An
increase in strike price causes a decrease in the value of a call option. (3) An increase in
19-2 Option’s strike price = $15; Exercise value = $22; Time value = $5;
V = ? P0 = ?
Using the Black-Scholes Option Pricing Model, you calculate the option’s value as:
−r t
V = P[N(d1)] – Xe
RF
[N(d2)]
= $25(0.5886) – $25e(–0.05)(0.5)(0.5047)
= $14.7150 – $25(0.9753)(0.5047)
= $2.4092 $2.41.
19-6 The stock’s range of payoffs in one year is $35 – $23 = $12. At expiration, the option
will be worth $35 – $30 = $5 if the stock price is $35, and zero if the stock price is $23.
The range of payoffs for the stock option is $5 – 0 = $5.
Equalize the range to find the number of shares of stock: Option range/Stock range =
$5/$12 = 0.4167.
With 0.4167 shares, the stock’s payoff will be either $14.58 or $9.58. The portfolio’s
payoff will be $14.58 – $5 = $9.58, or $9.58 – 0 = $9.58.
The present value of $9.58 at the daily compounded risk-free rate is PV = $9.58/(1+
(0.05/365))365 = $9.11.
The option price is the current value of the stock in the portfolio minus the PV of the
payoff:
Equalize the range to find the number of shares of stock: Option range/Stock range =
$4/$5 = 0.8.
With 0.8 shares, the stock’s payoff will be either 0.8($18) = $14.40 or 0.8($13) = $10.40.
The portfolio’s payoff will be $14.4 – $4 = $10.40, or $10.40 – 0 = $10.40.
The present value of $10.40 at the daily compounded risk-free rate is PV = $10.40/(1+
(0.06/365))365/2 = $10.093.
The option price is the current value of the stock in the portfolio minus the PV of the
payoff:
b.
If the stock goes to $122, the value of the option will be $22.
Likewise if the stock price goes to $82, then the value of the option will be $0.
If you sell one call option and create a riskless hedge by purchasing N shares, the value of
the portfolio at maturity will be (using stock price at $122), (0.55)($122) – $22 = $45.10.
$ 45.10
=$ 42.90
0.05 365
( 1+
365 )
Current option price = Current value of stock in portfolio – PV of portfolio
Current option price = (0.55)($100) – $42.90 = $12.10
If after 6 months the stock price is $115, then at maturity it can be $133 or $100.
If the stock price is $133, then the value of the option will be $33. If the stock price is
$100 then the value of the option will be $0.
Thus N at $115 is:
$ 33−0
=1
$ 133−$ 100
The value of the portfolio consisting of 1 share of stock and selling one call option will
be (1)($133) – $33 = (1)($100) – $0 = $100. The present value at six months will be:
$ 100
365
=$ 97.53
0.05
( 1+
365 ) 2
This implies the value of the option at this point is (1)($115) – $97.53 = $17.47
Likewise, if after 6 months the stock price is $87, then at maturity it will be $100 or $75.
In both situations the price of the option will be zero. This also implies N is 0 if the stock
price is $87 after six months. This also implies that the value of the portfolio is $0 and the
value of the option is $0 if at 6 months the realized stock price is $87.
At time zero, the stock price can go to $115 or to $87. The value of the option at the
respective nodes is $17.47 and $0. The N at time 0 is thus:
$ 17.47−$ 0
=0.6239
$ 115−$ 87
The value of the portfolio consisting of 0.6239 shares and selling one option at 6 months
will be (0.6239)($115) – $17.47 = (0.6239)($87) = $54.28. The present value will be:
$ 54.28
=$ 52.94
0.05 365
( 1+
365
2
)
This implies the initial value of the option is: (0.6239)($100) – $52.94 = $9.45
You have just been hired as a financial analyst by Triple Trice Inc., a mid-sized Ontario
company that specializes in creating exotic clothing. Because no one at Triple Trice is
familiar with the basics of financial options, you have been asked to prepare a brief report
that the firm's executives could use to gain at least a cursory understanding of the topic.
To begin, you gathered some outside materials on the subject and used these materials
to draft a list of pertinent questions that need to be answered. In fact, one possible
approach to the paper is to use a question-and-answer format. Now that the questions have
been drafted, you have to develop the answers.
Answer: A financial option is a contract that gives its holder the right to buy (or sell) an asset
at a predetermined price within a specified period of time. An option’s most
important characteristic is that it does not obligate its owner to take any action; it
merely gives the owner the right to buy or sell an asset.
b. Options have a unique set of terminology. Define the following terms: (1) call
option; (2) put option; (3) exercise price; (4) striking, or strike, price; (5) option
price; (6) expiration date; (7) exercise value; (8) covered option; (9) naked
option; (10) in-the-money call; (11) out-of-the-money call.
3. Exercise price is another name for strike price, the price stated in the option
contract at which the security can be bought (or sold).
4. The strike price is the price stated in the option contract at which the security
can be bought (or sold).
7. The exercise value is the value of a call option if it were exercised today, and it
is equal to the current stock price minus the strike price. Note: The exercise
value is zero if the stock price is less than the strike price.
10. An in-the-money call is a call option whose strike price is less than the current
price of the underlying stock.
11. An out-of-the-money call is a call option whose strike price exceeds the current
stock price.
c. In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option
Pricing Model (OPM).
The stock underlying the call option provides no dividends during the life of the
option.
No transactions costs are involved with the sale or purchase of either the stock or
the option.
The short-term, risk-free interest rate is known and is constant during the life of
the option.
Security buyers may borrow any fraction of the purchase price at the short-term,
risk-free rate.
Security trading takes place in continuous time, and stock prices move randomly
in continuous time.
d. What impact does each of the following call option parameters have on the value
of a call option?
Answer: 1. The value of a call option increases (decreases) as the current stock price
increases (decreases).
2. As the strike price of the option increases (decreases), the value of the option
decreases (increases).
3. As the expiration date of the option is lengthened, the value of the option
increases. This is because the value of the option depends on the chance of a stock
price increase, and the longer the option period, the higher the stock price can
climb.
4. As the risk-free rate increases, the value of the option tends to increase as well.
Since increases in the risk-free rate tend to decrease the present value of the
option's strike price, they also tend to increase the current value of the option.
5. The greater the variance in the underlying stock price, the greater the possibility
that the stock's price will exceed the strike price of the option; thus, the more
valuable the option will be.
Answer: Put-call parity specifies the relationship between puts, calls, and the underlying stock
price that must hold to prevent arbitrage:
2. Financial options help a manager to manage the financial risks such as uncertainty
to changes in interest rates, exchange rates, or commodity prices that a company
faces.
4. Financial options are useful in compensation plans as a company may grant stock
options to key employees in order to align their interests with the interests of the
company.