Answers to End-of-Chapter Problems
B-336
Chapter 23: Options and Corporate Finance:
Basic Concepts
23.1
a.
An
option
is a contract giving its owner the right to buy or sell an asset at a fixed price on
or before a given date.
b.
Exercise
is the act of buying or selling the underlying asset under the terms of the option
contract.
c.
The
strike price
is the fixed price in the option contract at which the holder can buy or sell
the underlying asset. The strike price is also called the exercise price.
d.
The
expiration date
is the maturity date of the option.
It is the last date on which an
American option can be exercised and the only date on which a European option can be
exercised.
e.
A
call option
gives the owner the right to buy an asset at a fixed price during a particular
time period.
f.
A
put option
gives the owner the right to sell an asset at a fixed price during a particular
time period.
23.2
An American option can be exercised on any date up to and including the expiration date. A
European option can only be exercised on the expiration date.
Since an American option gives
its owner the right to exercise on any date up to and including the expiration date, it must be
worth at least as much as a European option, if not more.
23.3
The put is not correctly priced.
An American put option must always be worth more than the
value of immediate exercise.
The value of immediate exercise for a put option equals the strike
price minus the current stock price.
In this problem, the value of immediate exercise is $5 (=
$40 - $35). Since the option is currently selling for $4.50, less than the value of immediate
exercise, the option is underpriced.
Consider the following investment strategy designed to
take advantage of the mispricing:
Strategy
Cash Flow
1. Buy put option
-$4.50
2. Buy stock
-$35.00
3. Exercise put option
+$40.00
Arbitrage Profit
+$0.50
Therefore, Mr. Nash should buy the option for $4.50, buy the stock for $35, and immediately
exercise the put option to receive its strike price of $40. This strategy yields a riskless, arbitrage
profit of $0.50 (=$5 - $4.50).
23.4 a.
If the option is American, it can be exercised on any date up to and including its expiration
on February 25.
b.
If the option is European, it can only be exercised on its expiration date, February 25.
c.
The option is not worthless. There is a chance that the stock price of Futura Corporation
will rise above $45 sometime before the option’s expiration on February 25. In this case, a
call option with a strike price of $45 would be valuable at expiration. The probability of
such an event happening is built into the current price of the option.

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