Assignment Multiple Choice Question

Practice
Please answer multiple choice questions and give a brief explanation for your answer.
1. A situation in which early exercise of an American put can be justified is
a. Bankruptcy
b. Merger
c. If X exceeds S0 by greater than any transaction costs
d. If S0 exceeds X by greater than any transaction costs
Why:
A
As the spot price of share is below the strike price and american option price
cannot provide huge returns
2. Which of the following statements about an American-style call option is
not true?
a. Its time value decreases as expiration approaches
b. Its maximum value is the stock price
c. It can be exercised prior to expiration
d. It pays dividends
Why:
D
No option pay dividends only stocks pay dividend
3.
Identify the correct statement regarding cash dividends.
a. Cash dividends raise call values and lower put values
b. Cash dividends lower call values and raise put values
c. Cash dividends raise call values and raise put values
d. Cash dividends do not change option values
Why:
B
Cash dividends affect option prices through their effect on the underlying stock
price. Because the stock price is expected to drop by the amount of the dividend
on the ex-dividend date, high cash dividends imply lower call premiums and higher
put premiums.
4. A call option is currently trading for $14.85 with an exercise price of $100. The
stock price is currently $101. The trader who is long this call option has the right to
buy the stock at
a. $14.85
b. $101
c. $100
d. $85.15
Why:
C
Since the trader has gone long at 100 it implies that the trader can buy the share
at 100 for the number of options purchased
5. What is the lowest possible value of a non-dividend paying
American-style call
assuming markets are in equilibrium?

a. max[0, S0 – PV(X)]
b. S0
c. max(0, S0 – X)
d. max[0, PV(S0) – X]
Why:
A
Since the stock is non dividend paying, the minimum value of the american call
option shall be higher of zero, spot price - strike price present value
6. Which of the following is the lowest possible value of an American-style put on a
stock with no dividends assuming markets are in equilibrium?
a. PV(X)
b. X
c. Max[0, PV(X) – S0]
d. Max(0, X – S0)
Why:
D
Since the stock is non dividend paying, the minimum value of the american put
option shall be higher of zero, strike price- spot price
7. In the single period binomial model, if a put option will expire in-the-money for
both the up and down move, the hedge ratio will be
a. 0.5
b. infinite
c. 1.0
d. –1.0
Why:
D
as the value of both up and down movement shall result in put optiob valuation
greater than zero and the difference between option values and shares values will
be same. Further the hedge ratio of put option is negative
8. In a binomial model, if the call price in the market is higher than the call price
given by the model, an arbitrage strategy would include (select the best answer)
a. sell the call and sell short the stock
b. buy the call and sell short the stock
c. buy the stock and sell the call
d. buy the call and buy the stock
Why:
C
since in arbitrage there is no risk borne, selling the call will be compensated by
buying the stock
9. In a two-period binomial world, a mispriced call will lead to an arbitrage profit if
a. the proper hedge ratio is maintained over the two periods
b. the hedge portfolio is terminated after one period
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c. the option goes from over- to underpriced or vice versa
d. the option remains mispriced over both periods
Why:
A
As for making profit if hedge ratio is not maintained, arbitraging is not possible. As
it symbolise making profit with no risk
10. In the single period binomial model, if a call option will expire in-the-money for
both the up and down move, the hedge ratio will be
a. 0.5
b. infinite
c. 1.0
d. 0.0
Why:
C
as the value of both up and down movement shall result in call option valuation
greater than zero and the difference between option values and shares values will
be same. Further the hedge ratio of put option is negative
11. Each of the following is a bullish strategy
except
a. a long call
b. a short put
c. a short stock
d. a protective put
Why:
C
in a short stock you are expecting market to fall and you are bearish on the stock
12. The effect of a decrease in volatility on an option’s price is a
a. decreased option price due to lower expected payout when the option is in
the money
b. nominal volatility will not noticeably effect an option’s price
c. increased price due to decreased possible gains
d. decreased price due to increased possible losses
Why:
D
Unlike interest rates, volatility significantly affects the option prices. The higher the
volatility of the underlying asset, the higher is the price for both call options and put
options. This happens because higher volatility increases both the up potential and
down potential. The upside helps calls and downside helps put options.
13. If the stock price is $44, the exercise price is $40, the market put price is $1.54,
and the Black-Scholes-Merton put value using 23% as the volatility is $1.78, the
implied volatility will be
a. higher than 0.23
b. lower than 0.23
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c. 0.23
d. lower than the risk-free rate
Why:
B
As the value of option is lower than the value predicted using the formula
14. Protective put buying (PPB) is a popular trading strategy where one buys a stock
and buys a put. Identify the
false statement.
a. PPB sets a floor on portfolio losses
b. PPB results in a more positively skewed portfolio
c. PPB has historically resulted in higher average returns than the underlying
stock
d. PPB has a lower standard deviation than the underlying stock
Why:
B
PPB generally results in lower positively skewed portfolio
15. A bull put spread option strategy is best described as
a. a position in two put option contracts with the same strike price where one has
a shorter time to maturity.
b. a position in two call option contracts with the same expiration where one is
long a high strike price put and short a low strike price put.
c. a position in two put option contracts with the same expiration where one is
short a high strike price put and long a low strike price put.
d. a position in two put option contracts with the same expiration where one is
long a high strike price put and short a low strike price put.
Why:
C
A bull put spread consists of two put options. First, an investor buys a put option
and pays a premium. Next, the investor sells a put option at a higher strike price
than the purchased put receiving a premium. Both options have the same
expiration date.
16. Capital investment projects often contain embedded options that significantly
influence its current value. Identify the embedded option that is likely
not present
in the project.
a. Option to expand the project
b. Option to terminate the project
c. Some form of switch option where the project is modified in light of changing
market conditions
d. All of the above are likely present in many capital investment projects
Why:
D
As all the options are available in the project
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