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CHAPTER17OPTIONSANDCORPORATEFINANCEAnswerstoConceptQuestions1.Acalloptionconferstheright,withouttheobligation,tobuyanassetatagivenpriceonorbeforeagivendate.Aputoptionconferstheright,withouttheobligation,tosellanassetatagivenpriceonorbeforeagivendate.Youwouldbuyacalloptionifyouexpectthepriceoftheassettoincrease.Youwouldbuyaputoptionifyouexpectthepriceoftheassettodecrease.Acalloptionhasunlimitedpotentialprofit,whileaputoptionhaslimitedpotentialprofit;theunderlyingasset’spricecannotbelessthanzero.2.a.Thebuyerofacalloptionpaysmoneyfortherighttobuy....b.Thebuyerofaputoptionpaysmoneyfortherighttosell....c.Thesellerofacalloptionreceivesmoneyfortheobligationtosell....d.Thesellerofaputoptionreceivesmoneyfortheobligationtobuy....3.AnAmericanoptioncanbeexercisedonanydateuptoandincludingtheexpirationdate.AEuropeanoptioncanonlybeexercisedontheexpirationdate.SinceanAmericanoptiongivesitsownertherighttoexerciseonanydateuptoandincludingtheexpirationdate,itmustbeworthatleastasmuchasaEuropeanoption,ifnotmore.4.TheintrinsicvalueofacallisMax[S–E,0].TheintrinsicvalueofaputisMax[E–S,0].Theintrinsicvalueofanoptionisthevalueatexpiration.5.Thecallissellingforlessthanitsintrinsicvalue;anarbitrageopportunityexists.Buythecallfor$10,exercisethecallbypaying$35inreturnforashareofstock,andsellthestockfor$50.You’vemadeariskless$5profit.6.Thepricesofboththecallandtheputoptionshouldincrease.Thehigherlevelofdownsideriskstillresultsinanoptionpriceofzero,buttheupsidepotentialisgreatersincethereisahigherprobabilitythattheassetwillfinishinthemoney.7.False.Thevalueofacalloptiondependsonthetotalvarianceoftheunderlyingasset,notjustthesystematicvariance.8.Thecalloptionwillsellformoresinceitprovidesanunlimitedprofitopportunity,whilethepotentialprofitfromtheputislimited(thestockpricecannotfallbelowzero).9.Thevalueofacalloptionwillincrease,andthevalueofaputoptionwilldecrease.10.Thereasontheydon’tshowupisthattheU.S.governmentusescashaccounting;i.e.,onlyactualcashinflowsandoutflowsarecounted,notcontingentcashflows.Fromapoliticalperspective,theywouldmakethedeficitlarger,sothatisanotherreasonnottocountthem!Whethertheyshouldbeincludeddependsonwhetherwefeelcashaccountingisappropriateornot,butthesecontingentliabilitiesshouldbemeasuredandreported.Theycurrentlyarenot,atleastnotinasystematicfashion.11.Increasingthetimetoexpirationincreasesthevalueofanoption.Thereasonisthattheoptiongivestheholdertherighttobuyorsell.Thelongertheholderhasthatright,themoretimethereisfortheoptiontoincrease(ordecreaseinthecaseofaput)invalue.Forexample,imagineanout-of-the-moneyoptionthatisabouttoexpire.Becausetheoptionisessentiallyworthless,increasingthetimetoexpirationwouldobviouslyincreaseitsvalue.12.Anincreaseinvolatilityactstoincreasebothcallandputvaluesbecausethegreatervolatilityincreasesthepossibilityoffavorablein-the-moneypayoffs.13.Aputoptionisinsurancesinceitguaranteesthepolicyholderwillbeabletoselltheassetforaspecificprice.Considerhomeownersinsurance.Ifahouseburnsdown,itisessentiallyworthless.Inessence,thehomeownerissellingtheworthlesshousetotheinsurancecompanyfortheamountofinsurance.14.Theequityholdersofafirmfinancedpartiallywithdebtcanbethoughtasholdingacalloptionontheassetsofthefirmwithastrikepriceequaltothedebt’sfacevalueandatimetoexpirationequaltothedebt’stimetomaturity.Ifthevalueofthefirmexceedsthefacevalueofthedebtwhenitmatures,thefirmwillpayoffthedebtholdersinfull,leavingtheequityholderswiththefirm’sremainingassets.However,ifthevalueofthefirmislessthanthefacevalueofdebtwhenitmatures,thefirmmustliquidateallofitsassetsinordertopayoffthedebtholders,andtheequityholdersreceivenothing.Considerthefollowing:LetVL=thevalueofafirmfinancedwithbothdebtandequityFV(debt)=thefacevalueofthefirm’soutstandingdebtatmaturityIfVLFV(debt)IfVLFV(debt)PayofftodebtholdersVLFV(debt)Payofftoequityholders0VL–FV(debt)VLVLNoticethatthepayofftoequityholdersisidenticaltoacalloptionoftheformMax(0,ST–K),wherethestockpriceatexpiration(ST)isequaltothevalueofthefirmatthetimeofthedebt’smaturityandthestrikeprice(K)isequaltothefacevalueofoutstandingdebt.15.Sinceyouhavealargenumberofstockoptionsinthecompany,youhaveanincentivetoacceptthesecondproject,whichwillincreasetheoverallriskofthecompanyandreducethevalueofthefirm’sdebt.However,acceptingtheriskyprojectwillincreaseyourwealth,astheoptionsaremorevaluablewhentheriskofthefirmincreases.16.Rearrangingtheput-callparityformula,weget:S–PV(E)=C–P.Sinceweknowthatthestockpriceandexercisepricearethesame,assumingapositiveinterestrate,thelefthandsideoftheequationmustbegreaterthanzero.Thisimpliesthepriceofthecallmustbehigherthanthepriceoftheputinthissituation.17.Rearrangingtheput-callparityformula,weget:S–PV(E)=C–P.Ifthecallandtheputhavethesameprice,weknowC–P=0.Thismustmeanthestockpriceisequaltothepresentvalueoftheexerciseprice,sotheputisin-the-money.18.Astockcanbereplicatedusingalongcall(tocapturetheupsidegains),ashortput(toreflectthedownsidelosses)andaT-bill(toreflectthetimevaluecomponent–the“wait”factor).SolutionstoQuestionsandProblemsNOTE:Allend-of-chapterproblemswe