Ross5eChap23sm - Chapter 23: Options and Corporate Finance:...

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Chapter 23: Options and Corporate Finance: Basic Concepts 23.1 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. a. Exercise is the act of buying or selling the underlying asset under the terms of the option contract. b. 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. c. 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. d. A call option gives the owner the right to buy an asset at a fixed price during a particular time period. e. 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 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. 23.4 a. If the option is American, it can be exercised on any date up to and including its expiration on February 14. b. If the option is European, it can only be exercised on its expiration date, February 14. c. The option is not worthless. There is a chance that the stock price of Futura Corporation will remain above $47 sometime before the option’s expiration on February 14. In this case, a call option with a strike price of $47 would be valuable at expiration. The probability of such an event happening is built into the current price of the option. 23.5 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, $65–$60 ] = $5 b. The payoff to the seller of a call option at expiration is the minimum of zero and the strike price minus the current stock price. The payoff to the seller of a call option on Stock A on December 21 is: min[0, K– S T ] = min[0, $60–$65] = –$5 In other words, the seller must pay $5. c. 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: Answers to End-of-Chapter Problems B- 80
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max[0, S T – K] = max[0, $55–$60] = $0 d.
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This note was uploaded on 07/18/2010 for the course ECONMICS ECM359 taught by Professor Matazi during the Summer '10 term at University of Toronto- Toronto.

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Ross5eChap23sm - Chapter 23: Options and Corporate Finance:...

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