Reading 55: pricing and valuations of options

Question 1

The price of an out-of-the-money option is:
less than its time value.
equal to its time value.
greater than its time value.

Answer 1

Because an out-of-the-money option has an exercise value of zero, its price is its time value. (LOS 55.a)

Question 2

The lower bound for the value of a European put option is:
Max(0, S – X)
Max[0, X(1 + Rf)–(T–t) – S]
Max[0, S – X(1 + Rf)–(T–t)]

Answer 2

The lower bound for a European put ranges from zero to the present value of the exercise price less the current stock price, where the exercise price is discounted at the risk-free rate. (LOS 55.b)

Question 3

A decrease in the risk-free rate of interest will:
increase put and call option prices.
decrease put option prices and increase call option prices.
increase put option prices and decrease call option prices.

Answer 3

A decrease in the risk-free rate will decrease call option values and increase put option values. (LOS 55.c)