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Unformatted text preview: Chapter 22: Options and Corporate Finance: Basic Concepts 22.1 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. 22.2 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. 22.3 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). 22.4 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 options 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. 22.5 a. The payoff to the owner of a call option at expiration is the maximum of zero and the current stock price minus the strike price. The payoff to the owner of a call option on Stock A on December 21 is: max[0, S T - K] = max[0, 55-50] = $5 where S T = the price of the underlying asset at expiration K = the strike price B-115 b. The payoff to the seller of a call option at expiration is the minimum of zero and the strike price...
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- Spring '08