Session 17 - Reading 71 Option Markets and Contracts - LOS n

CFA Level 1 - Derivative Investments Session 17 - Reading 71 Option Markets and Contracts - LOS n (Notes, Practice Questions, Sample Questions) 1. The value of an American option can equal that of a European option with the same maturity, exercise price, and underlying stock when: A) the owner of the American option chooses to exercise the optionbefore maturity. B) the owner of the American option holds the option until maturity. C) the seller of the American option does not allow the holder toexercise before maturity. {Explanation}: (B) If two options are identical (maturity, underlyingstock, strike price, etc.) in all ways, except one is a European optionand the other is an American option, the value of the Americanoption will equal or exceed the value of the European option. Why?The American option has more flexibility than the European option,so it should be worth more. If you choose not to exercise theAmerican option, it will be equal to the European option and havethe same value.The other statements are false. Exercise is at the option of theholder, not the writer

2. Which of the following is least likely a valid reason to trade options? A) Exchange-traded options can be modified to exactly match thedesired exposure to the underlying. B) Options can be combined with stocks to perform like risk-free bonds.C) Option prices are more volatile than the underlying stock price {Explanation}: (A) Exchange-traded options are standardized topromote market liquidity. Since the contract terms cannot bemodified, the exposure may or may not exactly match what is desired 3. There are two different options available with ITM Corporation common stock as the underlying asset. They each have the samematurity date, a strike price of $40.00, and are identical in all otherways except, one is a European call, and the other is an American call.ITM stock has a market value of $43.75. The American call option isselling for $4.90. For the European call, which of the following optionpremiums is most likely? A) $4.25. B) $4.90.C) $5.25. {Explanation}: (A) Both the American and European calls have astrike price of $40.00. Each call is therefore in-the-money by $3.75($43.75 - $40.00). Since they are identical in all ways except whenthey can be exercised, and since European calls are less flexible thanAmerican, their market value, option premium, will most likely belower. The lower option premium will allow for a higher return onthe European option relative to the American, assuming both are

held to expiration. This higher return is compensation for thereduced flexibility of the option terms 4. American options are worth no less than European options with the same maturity, exercise price, and underlying stock because: A) both of these choices are correct.B) purchasers of American options receive stock dividends, whilepurchasers of European options do not. C) American options can be exercised before maturity, whileEuropean options can be exercised only at maturity. {Explanation}: (C) By definition 5. ABEX Corporation common stock is selling for $50.00 per share. Both an American call option and a European call option are availableon ABEX common, and each have identical strike prices and expirationdates. Which of the following statements concerning these two optionsis CORRECT? A) The greater flexibility allowed in exercising the American optionwill normally result in a higher market value relative to an otherwiseidentical European option. B) Because the American and European options have identical termsand are written against the same common stock, they will have identicaloption premiums.C) The European option will normally have a higher option premiumbecause of their relative scarcity compared to American options.

{Explanation}: (A) Trading in European options is considerably lessthan trading in American options, because demand for them is muchlower. This is due to their relative inflexibility regarding when theycan be exercised. The greater exercising flexibility of Americanoptions gives them increased value to traders, which normally resultsin a greater market value relative to an otherwise identical Europeanoption 6. Which of the following statements about options is least accurate? A) If an American option is exercised at expiration, its value will beless than that of a European option. B) Option prices are generally higher the longer the time until theoption expires.C) For put options, the higher the strike price relative to the stock'sunderlying price, the more the put is worth. {Explanation}: (A) The American option cannot be worth less thanthe European option 7. Which of the following statements about the early exercise of an option is least accurate? For an American: A) put option on an asset with no cash flows, early exercise issometimes optimal.B) call option on an asset with positive cash flows, early exercise issometimes profitable. C) call option, on an asset with no cash flows, early exercise can beprofitable if the option is far in the money.

{Explanation}: (C) Early exercise of an American call option on anasset with no cash flows is never profitable, they are worth more‘alive than dead’ 8. Compared to European put options on an asset with no cash flows, an American put option: A) will have the same lower bound on its price.B) will have a lower, lower bound on its price. C) will have a higher, lower bound on its price. {Explanation}: (C) Early exercise of an in-the-money American putoption on an asset with no cash flows can generate more, X ? S, thanthe minimum value of the European option, X / (1 + R)T ? S. Thepossibility of profitable early exercise leads to a higher, lower boundon the price of the American put option 9. Compared to European call options on an asset with no cash flows, an American call option: A) will have a higher, lower bound on its price. B) will have the same lower bound on its price. C) will have a lower, lower bound on its price {Explanation}: (B) Since early exercise of an American call option onan asset with no cash flows never generates more than the minimumvalue of the European option, early exercise is never profitable andthe lower bounds on prices of both types of options are the same