Question #91 - Reading 31 Valuation of Contingent Claims

Reading: Reading 31 Valuation of Contingent Claims

PDF File: Reading 31 Valuation of Contingent Claims.pdf

Page: 42

Status: Unattempted

Correct Answer: B

Shared Context

- Bingly's sentiments towards the Black-Scholes-Merton (BSM) model regarding a lognormal distribution of prices and a variable risk-free rate are: A) correct for both reasons. B) correct concerning the distribution of stocks but incorrect concerning the risk-free rate. C) incorrect for both reasons.

Question

All else being equal, the greater the dividend paid by a stock the:

Answer Choices:

A. lower the call price and the higher the put price

B. lower the call price and the lower the put price

C. higher the call price and the lower the put price. John Fairfax is a recently retired executive from Reston Industries. Over the years he has accumulated $10 million worth of Reston stock and another $2 million in a cash savings account. He hires Richard Potter, CFA, a financial adviser from Stan Morgan, LLC, to help him develop investment strategies. Potter suggests a number of interesting investment strategies for Fairfax's portfolio. Many of the strategies include the use of various equity derivatives. Potter explains to Fairfax that there are numerous options available for him to obtain almost any risk return profile he might need. Potter suggests that Fairfax consider

Explanation

When dividend payments occur during the life of the option, the price of the underlying stock is reduced (on the ex-dividend date). All else being equal, the lower price reduces the value of call options and increases the value of put options. (Module 31.6, LOS 31.f) John Fairfax is a recently retired executive from Reston Industries. Over the years he has accumulated $10 million worth of Reston stock and another $2 million in a cash savings account. He hires Richard Potter, CFA, a financial adviser from Stan Morgan, LLC, to help him develop investment strategies. Potter suggests a number of interesting investment strategies for Fairfax's portfolio. Many of the strategies include the use of various equity derivatives. Potter explains to Fairfax that there are numerous options available for him to obtain almost any risk return profile he might need. Potter suggests that Fairfax consider options on both Reston stock and the S&P 500. Potter collects the information needed to evaluate options for each security. These results are presented in Table 1. Table 1: Option Characteristics Reston S&P 500 Stock price $50.00 $1,400.00 Strike price $50.00 $1,400.00 Interest rate 6.00% 6.00% Dividend yield 0.00% 0.00% Time to expiration (years) 0.5 0.5 Volatility 40.00% 17.00% Beta Coefficient 1.23 1 Correlation 0.4 Potter presents Fairfax with the prices of various options as shown in Table 2. Table 2 details standard European calls and put options. Potter presents the option sensitivities in Potter presents Fairfax with the prices of various options as shown in Table 3and Potter presents Fairfax with the prices of various options as shown in Table 4. Table 2: Regular and Options (Option Values) Reston S&P 500 European call $6.31 $6.31 European put $4.83 $4.83 American call $6.28 $6.28 American put $4.96 $4.96 Table 3: Reston Stock Option Sensitivities Delta European call 0.5977 European put −0.4023 American call 0.5973 American put −0.4258 Table 4: S&P 500 Option Sensitivities Delta European call 0.622 European put −0.378 American call 0.621 American put −0.441

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