OPTIONS AND CORPORATE FINANCE
Answers to Concepts Review and Critical Thinking Questions
A call option confers the right, without the obligation, to buy an asset at a given price on or before a
given date. A put option confers the right, without the obligation, to sell an asset at a given price on
or before a given date. You would buy a call option if you expect the price of the asset to increase.
You would buy a put option if you expect the price of the asset to decrease. A call option has
unlimited potential profit, while a put option has limited potential profit; the underlying asset’s price
cannot be less than zero.
The buyer of a call option pays money for the right to buy.
The buyer of a put option pays money for the right to sell.
The seller of a call option receives money for the obligation to sell.
The seller of a put option receives money for the obligation to buy.
The intrinsic value of a call option is Max [S – E,0]. It is the value of the option at expiration.
The value of a put option at expiration is Max[E – S,0]. By definition, the intrinsic value of an option
is its value at expiration, so Max[E – S,0] is the intrinsic value of a put option.
The call is selling for less than its intrinsic value; an arbitrage opportunity exists. Buy the call for
$10, exercise the call by paying $35 in return for a share of stock, and sell the stock for $50. You’ve
made a riskless $5 profit.
The prices of both the call and the put option should increase. The higher level of downside risk still
results in an option price of zero, but the upside potential is greater since there is a higher probability
that the asset will finish in the money.
False. The value of a call option depends on the total variance of the underlying asset, not just the
The call option will sell for more since it provides an unlimited profit opportunity, while the
potential profit from the put is limited (the stock price cannot fall below zero).
The value of a call option will increase, and the value of a put option will decrease.
The reason they don’t show up is that the U.S. government uses cash accounting; i.e., only actual
cash inflows and outflows are counted, not contingent cash flows. From a political perspective, they
would make the deficit larger, so that is another reason not to count them!
Whether they should be
included depends on whether we feel cash accounting is appropriate or not, but these contingent
liabilities should be measured and reported. They currently are not, at least not in a systematic
The option to abandon reflects our ability to shut down a project if it is losing money. Since this
option acts to limit losses, we will underestimate NPV if we ignore it.