Questions -

Q1. Andrea wrote a three-month call on Echo stock. The option contract cost $200 and the strike price was $10. What does the market price of Echo have to be for Andrea to break-even on this investment if the option is exercised? Ignore transaction construed taxes. Show all calculations. Graph in Excel and label your graph.

Q2. Rex bought a put on Alpha stock with a strike price of $35 when the market price of Alpha stock was $33 a share. Alpha is currently selling at $34 a share. Which of the following statement/s are true given this information?

I. Rex's option is worth at least $100 today.

II. Rex's option is worthless today.

III. Rex's option has more value today than when he bought it. IV. Rex's option has less value today than when he bought it. Explain

Q3. Allison bought 100 shares (1 round lot) of MIKO, Inc. stock at a price of $35 a share. In addition, she bought a 35 put on MIKO at a cost of $125 (1 contract). Which of the following are true about Allison's position from now until the option expiration date?

I. Her maximum loss is $3,625.

II. Her maximum loss is $125.

III. Her minimum gain is $125.

IV. Her maximum profit is unlimited. Explain  

Q4. Mary wrote a 40 call on ABC stock at a price of $275 (1 contract). She does not own any shares of ABC. Mary has

I. limited her losses to $275.

II. unlimited loss potential.

III. limited her gains to $275.

IV. unlimited profit potential. Explain

Q5. Amy owns 100 shares (1 round lot) of ABC stock with a cost basis of $35 a share. The stock is currently trading at $54 a share. Amy believes the price of ABC stock will fall to $45 a share in the near future but over the longer term of 3 to 5 years, increase in value to $75 a share. Amy would like to benefit from the expected near-term decline if it occurs. Therefore, Amy writes a call covered (= not naked) at a strike price of $55 and a premium of $2.

(a) How will the call help Amy profit if the expected price decline occurs? Explain What would be her total profits? Show all calculations.

(b) What is the maximum loss Amy can incur from the call? Explain What would be her total profits? Show all calculations.

(c) What is the maximum profit Amy can incur from the call? Explain.

Q6. Taggart Transcontinental's stock has a volatility of 25% and a current stock price of $40 per share. Taggart pays no dividends. The risk-free interest rate is 4%. The Black-Scholes value of a one-year, at-the-money call option on Taggart stock is closest to:

Show all calculations.

Q7. Taggart Transcontinental's stock has a volatility of 25% and a current stock price of $40 per share. Taggart pays no dividends. The risk-free interest rate is 4%. Consider a one-year, atthe-money put option on Taggart stock. The effect on the price of this put option of an increase in the risk-free rate from 4% to 6% is closest to:

Show all calculations.

Q8. Luther Industries is considering launching a new toy just in time for the Christmas season.  They estimate that if Luther launches the new toy this year it will have an NPV of $25 million.  Luther has the option to wait one year until the next Christmas season to launch the toy, however, the demand next year will depend upon what new toys Luther's competitors introduce and therefore greater uncertainty about next year's demand.  Launching the new today will involve a total capital expenditure of $100 million.  If the risk-free rate is 5%, sigma is 20% (σ), then what is the value of the option to wait until next year to launch the new toy? 

Show all calculations.

Q9. Taggart Transcontinental's stock has a variance of 6.25% and a current stock price of $40 per share. Taggart pays $1 dividend every quarter. The risk-free interest rate is 4%. The BlackScholes value of a one-year, at-the-money put option on Taggart stock is closest to:

 Show all calculations.

Q10. The Bush Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project would cost $8 million today. Bush estimates that once drilled, the oil will generate positive net cash flows of $4 million a year at the end of each of the next 4 years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits 2 years, it would have more information about the local geology as well as the price of oil. Bush estimates that if it waits 2 years, the project would cost $9 million. Moreover, if it waits 2 years, there is a 90 percent chance that the net cash flows would be $4.2 million a year for 4 years, and there is a 10 percent chance that the cash flows would be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 10 percent. 

a) If the company chooses to drill today, what is the project's net present value? 

b) Would it make sense to wait 2 years before deciding whether to drill? Explain.

c) What is the value of the investment timing option?

d) What disadvantages might arise from delaying a project like this drilling project?

Q11. Llao Llao S.A. is interested in developing a new hotel in Bariloche (Argentina). The company estimates that the hotel would require an initial investment of $20 million and expects that the hotel will produce positive cash flows of $3 million a year at the end of the next 20 years. The project's cost of capital is 13 percent.

a) What is the project's net present value? 

b) While Llao Llao S.A. expects the cash flow to be $3 million a year, it recognizes that the cash flows could, in fact, be much higher or lower, depending on whether the Argentinean government imposes a large hotel tax. One year from now, Llao Llao S.A. will know whether the tax will be imposed. There is a 50% chance that the tax will be imposed, in which case the yearly cash flow will be only $2.2 million. At the same time, there is 50% chance that the tax will be not be imposed, in which case the yearly cash flow will be $3.8 million. The company is deciding whether to proceed with the hotel today or wait 1 year to find out whether the tax will be imposed. If Llao Llao S.A. waits a year, the initial investment will remain at $20 million. Assume that all cash flows are discounted at 13 %. Using decision tree analysis, should Llao Llao S.A. proceed with the project today or should it wait a year before deciding?

c) Use Black Scholes model to estimate the value of the option (assume: the variance of the project's rate of return is 6.87 percent and the risk free rate is 8%).