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BADM 710 Final Exam - (Terminology) Questions with Explanations of Answers | latest upate 2024
BADM 710 Final Exam - (Terminology) Questions with Explanations of Answers | latest upate 2024
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BADM 710 Final Exam - (Terminology)Option - ANS-A contract giving its owner the right, but not the obligation, to buy or sell an asset
at a fixed price on or before a given date; The buyer uses the option if it is advantageous to do
so - otherwise the option can be thrown away
Exercising the Option - ANS-The act of buying or selling the underlying asset
Strike (Exercise) Price - ANS-Refers to the fixed price in the option contract at which the holder
can buy or sell the underlying asset
Expiry (Expiration Date) - ANS-The maturity date of the option
American Option - ANS-An option that may be exercised anytime up to the expiration date
European Option - ANS-An option that can only be exercised on the expiration date
Call Option - ANS-The right, but not the obligation, to buy the underlying asset at a state price
within a specified time; Most common type of option
In the Money - ANS-Exercising the option would result in a positive payoff; The stock price is
greater than the exercise price
At the Money - ANS-Exercising the option would result in a zero payoff; The stock price is equal
to the spot price
Out of the Money - ANS-Exercising the option would result in a negative payoff; The value of the
common stock will turn out to be less than the exercise price
Call Option Payoffs, Profits - ANS-C = Max [ST - E, 0] ... ST is the value of the stock at expiry
(time T), E is the exercise price, C is the value of the call option at expiry; Theoretically, call
option payoffs are unlimited
Put Options - ANS-The right, but not the obligation, to sell the underlying asset at a stated price
within a specified time
Put Option Payoffs, Profits - ANS-C = Max [E - ST, 0] ... ST is the value of the stock at expiry
(time T), E is the exercise price, C is the value of the call option at expiry
Option Value - ANS-Option Premium = Intrinsic Value + Speculative Value
Intrinsic Value - ANS-Call = Max [ST - E, 0]; Put = Max [E - ST, 0]
, Speculative (Time) Value - ANS-The difference between the option premium and the intrinsic
value of the option before the option expires; More volatile the stock, higher the speculative
value (stock price could fluctuate positively or negatively before expiry)
Selling Options and Payoffs - ANS-Seller must deliver shares of the common stock if required to
do so by the call option holder; Obligated to do so; Receives option premium (exercise price) in
exchange
Combinations of Options - ANS-Puts and calls serve as building blocks for more complex option
contracts; Trading strategy, hedging, speculative purposes
Protective Put Strategy - ANS-Strategy of buying a put and the underlying stock; As if you are
buying insurance for the stock - stock can always be sold at the exercise price, regardless how
far the market price of the stock falls
Covered Call Strategy - ANS-Investors like to buy a stock and write a call on the stock
simultaneously; conservative strategy
Long Straddle - ANS-Buy a call and a put; Makes a profit as the stock price exceeds and moves
farther from the exercise price
Short Straddle - ANS-Sell a call and a put; Only loses money if the stock price moves past the
exercise price
Put-Call Parity - ANS-The value of a European call equals the value of the underlying stock and
a put minus the cost of investing in a risk-free asset such that the asset is worth the option strike
price at expiration; P0 + S0 = C0 + E/(1+ r)T ; Says there are two ways of buying a protective
put - You can buy a put and buy the underlying stock simultaneously or you can buy a call and
buy a zero coupon bond; Says a covered call is equivalent to selling a put and buying a zero
coupon bond
Option Value Determinants - ANS-Stock price increases (Call +, Put -); High exercise price (Call
-, Put +); High interest rate (Call +, Put -); Volatility in the stock price (Call +, Put +); Time to
expiry (Call +, Put +) [+ increases option value, - decreases option value]
Options and Mergers and Diversification - ANS-Mergers for diversification only transfer wealth
from the stockholders to the bondholders; If management's goal is to maximize stockholder
wealth, then mergers for reasons of diversification should not occur; Diversification reduces risk,
and therefore, volatility of the firm's return on assets; Decreasing volatility decreases the value
of an option
Options and Capital Budgeting - ANS-For a leveraged firm, the shareholders might prefer a
lower NPV project to a higher one (low NPV project increases volatility - shareholders
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