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CHAPTER 22
OPTIONS AND C ORPORATE FINANCE

Answers to Concept Questions

1. A call option confers the right, without the obligation, to buy an asset at a given price on or before a given date. A put option confers the right, without the obligation, to sell an asset at a given price on or before a given date. You would buy a call option if you expect the price of the asset to increase. You would buy a put option if you expect the price of the asset to decrease. A call option has unlimited potential profit, while a put option has limited potential profit; the underlying asset’s price cannot be less than zero.

2. a. The buyer of a call option pays money for the right to buy....
b. The buyer of a put option pays money for the right to sell....
c. The seller of a call option receives money for the obligation to sell....
d. The seller of a put option receives money for the obligation to buy....

3. An American option can be exercised on any date up to and including the expiration date. A European option can only be exercised on the expiration date. Since an American option gives its owner the right to exercise on any date up to and including the expiration date, it must be worth at least as much as a European option, if not more.

4. The intrinsic value of a call is Max[S – E, 0]. The intrinsic value of a put is Max[E – S, 0]. The intrinsic value of an option is the value at expiration.

5. The call is selling for less than its intrinsic value; an arbitrage opportunity exists. Buy the call for $10, exercise the call by paying $35 in return for a share of stock, and sell the stock for $50. You’ve made a riskless $5 profit.

6. The prices of both the call and the put option should increase. The higher level of downside risk still results in an option price of zero, but the upside potential is greater since there is a higher probability that the asset will finish in the money.

7. False. The value of a call option depends on the total...

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