Chapter 8 Financial Options and Their Valuation 8-1 a. An option is a contract which 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. | Chapter 8 Financial Options and Their Valuation ANSWERS TO END-OF-CHAPTER QUESTIONS 8-1 a. An option is a contract which 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. 8-2 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 premium over the exercise value. 8-3 1 An increase in stock price causes an increase in the value of a call option. 2 An increase in exercise price causes a decrease in the value of a call option. 3 An increase in the time to expiration causes an increase in the value of a call option. 4 An increase in the risk-free rate causes an increase in the value of a call option. 1 An .
