Put/Call Options Flashcards
Options
“The buyer of the call and the seller of the put both hope that the stock price will rise. Therefore the two positions are identical”. Is the speaker correct? Illustrate with a position diagram.
Both benefit from a rising stock price, but the positions are NOT identical.
“I am a conservative investor. I’d much rather hold a call option on a safe stock like Campbell Soup than a volatile stock like Google”. Comment.
First, call options have extreme risk/reward profiles and may not be the best investment for risk averse individuals, relative to, for example, safe bonds or low-beta stocks.
But more importantly, risk aversion has nothing to do with which call option is better. It is true that options are worth more if the underlying stock is more volatile, but SO IS THEIR ACQUISITION COST!
Unless you can purchase an option on Google for the same premium as an otherwise identical (in terms of time to maturity and moneyness) option on Campbell Soup, you should be indifferent between the two calls. At outset, purchasing either call is a NPV=0 investment.
“Canberry Petroleum (CP) is a leading downstream refiner and distributor of heating oil. Fearing a warm winter, CP sells oil futures at $1.60 a gallon for virtually its entire production. If spot heating oil prices this winter stay above $1.60, however, then CP will actually have lost money by selling oil futures at that price”. Comment. Do you agree? If so, why? If not, why not?
Find :
In narrow terms, yes, CP will have lost money by locking in a lower price than what it could have fetched had it not hedged. However, the point of hedging is to reduce risk, and that is what CP did. Hindsight is 20/20 as they say.
Suppose you buy a one-year European call option with an exercise price of $100 on the stock of Fells Wargo, the famous Northeast bank, and sell a one-year European put option on Fells Wargo with the same exercise price. The current stock price is $100, and the interest rate is 10%. How much will the combined position cost you?
Put call parity implies that: C-P=S-PV(K)=100-100/1.1=$9.09
Campbell Inc. and Guzman Corp. are in the same risk class. Both companies are market leaders in the disposable diaper business. Shareholders expect Campbell Inc. to pay a $4.00 dividend next year, at which time they also expect the stock to sell for $20.00. Guzman Corp. has a no-dividend policy. Currently, Guzman Corp. stock is selling for $20 per share. Guzman Corp. shareholders expect a $4.00 capital gain over the next year. Capital gains are not taxed, but dividends are taxed at 20%. What is the current price of Campbell Inc’s stock?
Guzman’s expected return is (24-20)/20 = 20%, which must be equal to the expected after tax return on Campbell’s shares, E(RC).
Thus:
E(RC)= .20= [(4)(1-.2) +20 - X]/X where X is current price.
solving for X yields X= $ 19.33
Salmon Sisters, the well-known New York investment bank, has succeeded in hiring ace foreign exchange trader Livingstone I. Presume. Mr. Presume’s remuneration package reportedly includes an annual bonus of 20% of the foreign exchange profits he generates in excess of $100 million. Does Mr. Presume have an option? If so, which kind? Does it provide him with the appropriate incentives?
The $100 million threshold can be viewed as an exercise price. Since he gains 20% of all FX profits in excess of this level, his payoff is comparable to that of a call option. The difference is that he does not have to literally ‘pay’ the $100 exercise price, but must ensure through his efforts that at least $100mm in profits are achieved. Whether this provides an adequate incentive depends on how achievable the $100 mm threshold is and how he evaluates his prospects of generating income greater than this amount. A possible undesirable incentive is that towards year-end, if current FX profits are much less than $100mm, his option-like payoff induces him to take excessive risks to try and make at least the threshold.
Which of the following increase(s) the value of a call option?
a) a high interest rate
b) a long time to maturity
c) a highly variable stock price
Suppose an investor buys 2 shares of stock and two put options on that stock. What will be the value of her investment on the final exercise date if the stock price is below the exercise price?
twice the exercise price
Liverpool Petroleum, the well-known UK oil company, just announced that its Gulf of Mexico oil field is expected to run dry much sooner than expected. As a result, LP decided that it would exit US oil exploration and production efforts and concentrate on its far less risky domestic UK gas pipeline and refining assets. These announcements cause the price of LP stock to decrease, but also cause a decrease in price volatility of the stock. Which of the following correctly identifies the impact of these changes on the call options on LP stock?
a) *both changes cause the price of the call to decrease
TRUE / FALSE When you buy a forward contract, you pay now for delivery at a future date.
FALSE
NO MONEY CHANGES HANDS UPFRONT
TRUE / FALSE Assume that a company postpones a major plant expansion. The expansion has positive NPV on a DCF basis, but top management wants to get a better fix on product demand before proceeding. We would say that “The company has an in-the-money call option on the project.”
TRUE
Put-call parity can be used to show:
The precise relation between put and call prices given equal exercise prices and equal expiration dates
Buying a call option and investing the present value of the exercise price in T-bills is the same as
Buying a PUT and a SHARE
The maximum value of a call option is equal to:
The price of the stock
Consider an electric utility that may use either coal or natural gas to generate electricity (this is called “co-firing”). Under which of the following circumstances would it be the LEAST valuable to have co-firing equipment? Let C be the annual standard deviation of coal prices, let G be the annual standard deviation of natural gas prices, and let R be the correlation between coal prices and natural gas prices.
C low, G low, R high
Cofiring is a switching option. Options have more value if volatility is high. If C and G are highly correlated, it will always make sense to continually use one (the cheaper one) over the other instead of switching between the two.
