HW15_Answers - Answers to End-of-Chapter Questions Q15-2....

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Answers to End-of-Chapter Questions Q15-2. Is buying an option more or less risky than buying the underlying stock? A15-2. The option is more risky than the underlying stock if the absolute dollar amounts invested in each is equal. With options, there is a very significant chance that the investor will lose 100% of the money invested. There is also a very good chance of a very high positive return. The likelihood of such extreme returns on stocks is very low. For example, investors can use options to enter a desired stock position over a period of time with less risk than the common stock today. i.e. Suppose a company has pending litigation, which should be settled within the next year. The stock currently trades at $100 and the investor wants to own 10,000 shares, but doesn’t want the risk of a possible negative outcome with the litigation. The investor could buy 100 calls (100 shares per contract × 100 calls = option to buy 10,000 shares) with a strike of $100 for $2.50 with a year till expiration. Now the investor is only putting up $25,000 (the stock could go to $0 and the investor would only lose the $25,000) purchase the option to buy 10,000 shares @ $100. If the investor bought the stock he\she would have to put up 10,000 × $100 = $1 million in capital. In this situation the options are less risky than the stock. Say the litigation was favorable the and the stock went to $115 within the year then the investor would make $12.50 per share (giving up $2.50 in option premium). If the litigation was negative and the stock price went to $85 the investor would only lose the $2.50/share (option premium) instead of $15/share
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This note was uploaded on 08/02/2008 for the course BUSFIN 1030 taught by Professor Zutter during the Spring '08 term at Pittsburgh.

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HW15_Answers - Answers to End-of-Chapter Questions Q15-2....

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