BADM 710 FINAL EXAM - (TERMINOLOGY) STUDY
GUIDE
Option - Answers - A contract giving its owner the right, but not the obligation, to buy or
sell an asset at a fixed price on or before a given date; The buyer uses the option if it is
advantageous to do so - otherwise the option can be thrown away
Exercising the Option - Answers - The act of buying or selling the underlying asset
Strike (Exercise) Price - Answers - Refers to the fixed price in the option contract at
which the holder can buy or sell the underlying asset
Expiry (Expiration Date) - Answers - The maturity date of the option
American Option - Answers - An option that may be exercised anytime up to the
expiration date
European Option - Answers - An option that can only be exercised on the expiration
date
Call Option - Answers - The right, but not the obligation, to buy the underlying asset at a
state price within a specified time; Most common type of option
In the Money - Answers - Exercising the option would result in a positive payoff; The
stock price is greater than the exercise price
At the Money - Answers - Exercising the option would result in a zero payoff; The stock
price is equal to the spot price
Out of the Money - Answers - Exercising the option would result in a negative payoff;
The value of the common stock will turn out to be less than the exercise price
Call Option Payoffs, Profits - Answers - C = Max [ST - E, 0] ... ST is the value of the
stock at expiry (time T), E is the exercise price, C is the value of the call option at expiry;
Theoretically, call option payoffs are unlimited
Put Options - Answers - The right, but not the obligation, to sell the underlying asset at a
stated price within a specified time
Put Option Payoffs, Profits - Answers - C = Max [E - ST, 0] ... ST is the value of the
stock at expiry (time T), E is the exercise price, C is the value of the call option at expiry
Option Value - Answers - Option Premium = Intrinsic Value + Speculative Value
, Intrinsic Value - Answers - Call = Max [ST - E, 0]; Put = Max [E - ST, 0]
Speculative (Time) Value - Answers - The difference between the option premium and
the intrinsic value of the option before the option expires; More volatile the stock, higher
the speculative value (stock price could fluctuate positively or negatively before expiry)
Selling Options and Payoffs - Answers - Seller must deliver shares of the common stock
if required to do so by the call option holder; Obligated to do so; Receives option
premium (exercise price) in exchange
Combinations of Options - Answers - Puts and calls serve as building blocks for more
complex option contracts; Trading strategy, hedging, speculative purposes
Protective Put Strategy - Answers - Strategy of buying a put and the underlying stock;
As if you are buying insurance for the stock - stock can always be sold at the exercise
price, regardless how far the market price of the stock falls
Covered Call Strategy - Answers - Investors like to buy a stock and write a call on the
stock simultaneously; conservative strategy
Long Straddle - Answers - Buy a call and a put; Makes a profit as the stock price
exceeds and moves farther from the exercise price
Short Straddle - Answers - Sell a call and a put; Only loses money if the stock price
moves past the exercise price
Put-Call Parity - Answers - The value of a European call equals the value of the
underlying stock and a put minus the cost of investing in a risk-free asset such that the
asset is worth the option strike price at expiration; P0 + S0 = C0 + E/(1+ r)T ; Says there
are two ways of buying a protective put - You can buy a put and buy the underlying
stock simultaneously or you can buy a call and buy a zero coupon bond; Says a
covered call is equivalent to selling a put and buying a zero coupon bond
Option Value Determinants - Answers - Stock price increases (Call +, Put -); High
exercise price (Call -, Put +); High interest rate (Call +, Put -); Volatility in the stock price
(Call +, Put +); Time to expiry (Call +, Put +) [+ increases option value, - decreases
option value]
Options and Mergers and Diversification - Answers - Mergers for diversification only
transfer wealth from the stockholders to the bondholders; If management's goal is to
maximize stockholder wealth, then mergers for reasons of diversification should not
occur; Diversification reduces risk, and therefore, volatility of the firm's return on assets;
Decreasing volatility decreases the value of an option
GUIDE
Option - Answers - A contract giving its owner the right, but not the obligation, to buy or
sell an asset at a fixed price on or before a given date; The buyer uses the option if it is
advantageous to do so - otherwise the option can be thrown away
Exercising the Option - Answers - The act of buying or selling the underlying asset
Strike (Exercise) Price - Answers - Refers to the fixed price in the option contract at
which the holder can buy or sell the underlying asset
Expiry (Expiration Date) - Answers - The maturity date of the option
American Option - Answers - An option that may be exercised anytime up to the
expiration date
European Option - Answers - An option that can only be exercised on the expiration
date
Call Option - Answers - The right, but not the obligation, to buy the underlying asset at a
state price within a specified time; Most common type of option
In the Money - Answers - Exercising the option would result in a positive payoff; The
stock price is greater than the exercise price
At the Money - Answers - Exercising the option would result in a zero payoff; The stock
price is equal to the spot price
Out of the Money - Answers - Exercising the option would result in a negative payoff;
The value of the common stock will turn out to be less than the exercise price
Call Option Payoffs, Profits - Answers - C = Max [ST - E, 0] ... ST is the value of the
stock at expiry (time T), E is the exercise price, C is the value of the call option at expiry;
Theoretically, call option payoffs are unlimited
Put Options - Answers - The right, but not the obligation, to sell the underlying asset at a
stated price within a specified time
Put Option Payoffs, Profits - Answers - C = Max [E - ST, 0] ... ST is the value of the
stock at expiry (time T), E is the exercise price, C is the value of the call option at expiry
Option Value - Answers - Option Premium = Intrinsic Value + Speculative Value
, Intrinsic Value - Answers - Call = Max [ST - E, 0]; Put = Max [E - ST, 0]
Speculative (Time) Value - Answers - The difference between the option premium and
the intrinsic value of the option before the option expires; More volatile the stock, higher
the speculative value (stock price could fluctuate positively or negatively before expiry)
Selling Options and Payoffs - Answers - Seller must deliver shares of the common stock
if required to do so by the call option holder; Obligated to do so; Receives option
premium (exercise price) in exchange
Combinations of Options - Answers - Puts and calls serve as building blocks for more
complex option contracts; Trading strategy, hedging, speculative purposes
Protective Put Strategy - Answers - Strategy of buying a put and the underlying stock;
As if you are buying insurance for the stock - stock can always be sold at the exercise
price, regardless how far the market price of the stock falls
Covered Call Strategy - Answers - Investors like to buy a stock and write a call on the
stock simultaneously; conservative strategy
Long Straddle - Answers - Buy a call and a put; Makes a profit as the stock price
exceeds and moves farther from the exercise price
Short Straddle - Answers - Sell a call and a put; Only loses money if the stock price
moves past the exercise price
Put-Call Parity - Answers - The value of a European call equals the value of the
underlying stock and a put minus the cost of investing in a risk-free asset such that the
asset is worth the option strike price at expiration; P0 + S0 = C0 + E/(1+ r)T ; Says there
are two ways of buying a protective put - You can buy a put and buy the underlying
stock simultaneously or you can buy a call and buy a zero coupon bond; Says a
covered call is equivalent to selling a put and buying a zero coupon bond
Option Value Determinants - Answers - Stock price increases (Call +, Put -); High
exercise price (Call -, Put +); High interest rate (Call +, Put -); Volatility in the stock price
(Call +, Put +); Time to expiry (Call +, Put +) [+ increases option value, - decreases
option value]
Options and Mergers and Diversification - Answers - Mergers for diversification only
transfer wealth from the stockholders to the bondholders; If management's goal is to
maximize stockholder wealth, then mergers for reasons of diversification should not
occur; Diversification reduces risk, and therefore, volatility of the firm's return on assets;
Decreasing volatility decreases the value of an option
