Global Finance

Global Financial Mgmt – Assign 3

Chapter 8: Questions 8-1 to 8 – 3

(8-1) a) Option - Is a contract that gives its owner the right to buy (or sell) an asset at

some predetermined price within a specified period of time.

Call Option – It gives its owner the right to buy a share of stock at a fixed price which is called the strike price.

Put Option – It gives the owner the right to sell a share of stock at a fixed strike price.

b) Exercise value – The profit from immediately exercising an option.

Strike price – The price at which you exercise the option.

c) Black-Scholes option pricing model – Used to estimate the value of a call option. It has five inputs in the model, they are (1)P, the current stock price, (2)X, the strike price, (3)rRF, the risk-free model interest rate, (4) t, the remaining time until expiration; and (5)σ, the standard deviation of the stock's rate of return.

(8-2) Why do options sell at prices higher than their exercise values? Because if the option's price were less than the exercise value, you could buy the option and immediately exercise it, and you would definitely reap a sure gain.

(8-3) Describe the effect on a call option's price that result from an increase in each of the following factors: (1) stock price (2) strike price (3) time to expiration (4) risk-free rate (5) standard deviation of stock return

(1) Stock price – The option price would increase if the stock price goes up, because the strike price is fixed. So an increase in the stock price would increase the chances that the option will be in-the-money at the close or expiration.

(2) Strike price – Increase in the strike price would decrease the options value because higher strike prices mean less of a chance of being in-the-money at close or expiration.

(3) Time to expiration – The longer the length of time the option has to expire the better the value. As the stock prices increase on average, and the more time until the expiration date the greater chance for the option to be in-the-money by its expiration date, making the option more valuable.

(4) Risk-free rate – When the risk free rate increases, the option increases.

(5) Standard deviation of stock return – If the volatility goes up, the option price goes up.

Therefore, the riskier the underlying security, the more valuable the option. 

Chapter 8: Problems 8- 1, 8-2, 8-3

1 2 3 4 5

price