Response to the following problem:
Assume that you have just been hired as a financial analyst by Triple Trice Inc., a mid-sized California company that specializes in creating exotic clothing. Because no one at Triple Trice is familiar with the basics of financial options, you have been asked to prepare a brief report that the firm's executives could use to gain at least 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 paper 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?
b. Options have a unique set of terminology. Define the following terms:
(1) Call option
(2) Put option
(3) Exercise price
(4) Striking, or strike, price
(5) Option price
(6) Expiration date
(7) Exercise value
(8) Covered option
(9) Naked option
(10) In-the-money call
(11) Out-of-the-money call
(12) LEAPS
c. Consider Triple Trice's call option with a $25 strike price. The following table contains historical values for this option at different stock prices:
Stock Price Call Option Price
$25 $ 3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50
(1) Create a table that shows
(a) stock price,
(b) strike price,
(c) exercise value,
(d) option price, and
(e) 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?
d. In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model (OPM).
(1) What assumptions underlie the OPM?
(2) Write out the three equations that constitute the model.
(3) What is the value of the following call option according to the OPM?
Stock price $27.00
Exercise price $25.00
Time to expiration 6 months
Risk-free rate 6.0%
Stock return variance 0.11
e. What impact do each of the following call option parameters have on the value of a call option?
(1) Current stock price
(2) Exercise price
(3) Option's term to maturity
(4) Risk-free rate
(5) Variability of the stock price
f. What is put-call parity?