Quiz 4

Solution
1) Which of the following statements is false?
A) Because an American option cannot be worth less than its intrinsic value, it cannot have
a negative time value.
B) An American option with a later exercise date cannot be worth less than an otherwise
identical American option with an earlier exercise date.
C) The value of an option generally increases with the volatility of the stock.
D) The intrinsic value is the amount by which the option is currently in-the-money or 0 if
the option is out-of-the-money.
E) None of the above
Answer: E

2) Consider the following equation:

C = S - K + dis(K) + P - PV(Div)
In this equation, dis(K) + P - PV(Div) tells us:
A) the market value of the option
B) the difference in the price of an American option over a European option because of
dividend capture
C) the intrinsic value of the option
D) the time value of the option
E) None of the above

Answer: D

3) Which of the following statements is false?

A) The intrinsic value of an option is the value it would have if it expired immediately.
B) A European option cannot be worth less than its American counterpart.
C) Put options increase in value as the stock price falls.
D) A put option cannot be worth more than its strike price.
E) None of the above

Answer: B

4) The intrinsic value of an option is the value it would have:

A) if it approached to its exercise price
B) if it approached to its strike price
C) if it expired immediately
D) if it approached to its fixed price
E) None of the above

Answer: C

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5) Luther Industries is currently trading for $27 per share. The stock pays no dividends. A
one-year European put option on Luther with a strike price of $30 is currently trading for
$2.60. If the risk-free interest rate is 6% per year, then the price of a one-year European
call option on Luther with a strike price of $30 will be closest to:
A) $0.30
B) $7.10
C) $2.60
D) $3.95
E) None of the above

Answer: E
Explanation: C = P + S - PV(K) - PV(Div)
C = $2.60 + $27 - - $0 = $1.2981

6) Which of the following statements is false?

A) If there is a lot of uncertainty, the benefit of waiting is diminished.
B) In the real option context, the dividends correspond to any value from the investment
that we give up by waiting.
C) By delaying an investment, we can base our decision on additional information.
D) Given the option to wait, an investment that currently has a negative NPV can have a
positive value.
E) None of the above

Answer: A
Explanation: If there is a lot of uncertainty, the benefit of waiting is increased.

7) Which of the following statements is false?

A) If the value of the firm's assets exceeds the required debt payment, debt holders are fully
repaid.
B) Another way to view corporate debt is as a portfolio of riskless debt and a short position
in a call option on the firm's assets with a strike price equal to the required debt payment.
C) Viewing debt as an option portfolio is useful as it provides insight into how credit
spreads for risky debt are determined.
D) You can think of the debt holders as owning the firm and having sold a call option with a
strike price equal to the required debt payment.
E) None of the above

Answer: B
Explanation: Another way to view corporate debt is as a portfolio of riskless debt and a
short position in a put option on the firm's assets with a strike price equal to the required
debt payment.

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8) Prior to an IPO, in Canada, the first step is the preparation of:
A) the audited financial statements and the registration statement
B) the registration statement only
C) the preliminary prospectus and the registration statement
D) the preliminary prospectus only
E) None of the above

Answer: D

9) The two advantages of going public are ________ and ________.

A) greater liquidity; better access to capital
B) better cash flows; better access to capital
C) greater liquidity; better access to free cash
D) greater liquidity; better control
E) None of the above

Answer: A

10) Luther Industries is in the process of selling shares of stock in an auction IPO. At the
end of the bidding period, Luther's investment bank has received the following bids:

Price ($) Number of Shares Bid

$19.10 90,000
$19.00 115,000
$18.75 120,000
$18.50 75,000
$18.25 150,000
$18.00 240,000
$17.75 80,000
$17.50 125,000
$17.25 150,000
$17.00 100,000
$16.90 60,000

What will the offer price of these shares be if Luther is selling 1 million shares?

A) $19.10
B) $17.50
C) $17.25
D) $16.90
E) None of the above

Answer: C

Price ($) Number of Shares Bid Cumulative Demand

$19.10 90,000 90,000

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$19.00 115,000 205,000
$18.75 120,000 325,000
$18.50 75,000 400,000
$18.25 150,000 550,000
$18.00 240,000 790,000
$17.75 80,000 870,000
$17.50 125,000 995,000
$17.25 150,000 1,145,000
$17.00 100,000 1,245,000
$16.90 60,000 1,305,000

By looking at cumulative demand, we see that a cumulative demand of 1 million shares

corresponds to a price of $17.25.

11) Which of the following is NOT one of the four characteristics of IPOs that puzzle
financial economists?
A) On average, IPOs appear to be underpriced.
B) The long-run performance of a newly public company (three to five years from the date of
issue) is superior to the overall market return.
C) The number of issues is highly cyclical.
D) The costs of the IPO are very high, and it is unclear why firms willingly incur such high
costs.
E) None of the above

Answer: B
Explanation: The long-run performance of a newly public company (three to five years from
the date of issue) is inferior to the overall market return.

12) Which of the following statements is false?

A) An American call on a non-dividend-paying stock has the same price as its European
counterpart.
B) The price of any call option on a non-dividend-paying stock always exceeds its intrinsic
value.
C) It is never optimal to exercise a call option on a dividend-paying stock early – you are
always better off just selling the option.
D) If the present value of the dividend payment is large enough, the time value of a
European call option can be negative, implying that its price could be less than its intrinsic
value.
E) None of the above

Answer: C
Explanation: It is never optimal to exercise a call option on a non-dividend-paying stock
early – you are always better off just selling the option.

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13) Which of the following statements is false?
A) In particular, because real options allow a decision maker to choose the most attractive
alternative after new information has been learned, the presence of real options adds value
to an investment opportunity.
B) To make an investment decision correctly, the value of embedded real options must be
included in the decision-making process.
C) A key distinction between a real option and a financial option is that real options, and
the underlying assets on which they are based, are often traded in competitive markets.
D) We can compute the value of the real option by comparing the expected profit without
the real option to the value with the option.
E) None of the above

Answer: C
Explanation: A key distinction between a real option and a financial option is that real
options, and the underlying assets on which they are based, are not traded in competitive
markets.

14) Which of the following is not a real option?

A) A stock option
B) An abandonment option
C) An investment timing option
D) An expansion option
E) None of the above

Answer: A

15) Which of the following statements regarding best efforts IPOs is false?
A) For smaller IPOs, the underwriter commonly accepts the deal on this basis.
B) The underwriter does not guarantee that the stock will be sold, but instead tries to sell
the stock for the best possible price.
C) Often these arrangements have an all-or-none clause: either all of the shares are sold
in the IPO, or the deal is called off.
D) If the entire issue does not sell out, the underwriter is on the hook.
E) None of the above

Answer: D
Explanation: If the entire issue does not sell out, the underwriter is off on the hook since
this is not a firm commitment offering.