Chapter 8. Mini-Case
Assume that you have just been hired as a financial analyst by Triple Play Inc., a mid-sized California company that specializes in creating high-fashion clothing. Because no one at Triple Play is familiar with the basics of financial options, you have been asked to prepare a brief report that firm’s executives can use to gain a cursory understanding of the topic. To begin, you gathered some outside materials on the subject and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the report is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers. a. What is a financial option? What is the single most important characteristic of an option? Financial option is a contract that gives its owner the right to buy (or sell) an asset at some predetermined price within a specified period of time. The single most important characteristic of an option is that although it gives the right to buy (or sell), it does not obligate the holder to do so.
b. Options have a unique set of terminology. Define the following terms: (1) Call Option: Gives the owner the right to buy a share of stock at a fixed price, that is, the strike of exercise price. (2) Put Option: Gives the owner the right to sell a share of stock at a fixed price, that is, the strike of exercise price. (3) Strike Price or Exercise Value: The price at which the holder of an option decides to exercise the option. (4) Expiration date: This is the day after which the option cannot be exercised. (5) Exercise value: This is any profit from immediately exercising an option. (6) Option price: Option price is the value at which the option is sold. (7) Time Value: The time value is the option’s price less its exercise value. (8)Writing an option: This is the position of selling the option, whether put or call option. (9) Covered option: This is selling options against stocks held in portfolio. (10) Naked option: These are options sold without stocks to back them up (11) In-the-money call: This is when the current stock price is greater than the strike price for call options or when the current stock price is smaller than the strike price for put options. In other words when there is a payoff from exercising the option. (12)Out-of-the-money call: This is when the current stock price is below the strike price for call options or when the current stock price is greater than the strike price for put options. In other words when there is no payoff from exercising the option. (13) LEAPS: Long-Term Equity Anticipation Security are like conventional options and are listed on exchanges in stocks and stock indexes but differ in the expiration length as some LEAPS can last until 3 years for expiration and provide buyers with more potential for gains and offer long-term protection for a portfolio. c. Consider Triple Play’s call option with a $25 strike price. The following table contains historical values for this option at different stock prices. (1) Create a table that shows:
The time value
Which is the option’s price less its exercise value?
(2) What happens to the time value as the stock price rises? Why? As the stock price rises, the option price rises as well, but the effect on time value is that it decreases as the stock price increases. d. Consider a stock with a current price of P=$27. Suppose that over the next 6 months the stock price will either go up by a factor of 1.41 or down by a factor of 0.71. Consider a call option on the stock with a strike price of $25 that expires in 6 months. The risk-free rate is 6%.
1) Using the binomial model, what are the ending values of the...
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