Problem set 8

Triple A Company is a mid-sized California company that specializes in creating high-fashion clothing. The company executives want to understand financial options and its application in corporate finance because many projects of the company allow managers to make strategic or tactical changes in plans depending on changes in market conditions. Management believes that understanding financial options can help them to manage the value inherent in real options. Also, the company would like to manage risk using financial options. Management wants to make optimal capital structure decisions by issuing convertible bonds in the market and thinks that financial options can guide them to make right decisions. A supervisor at the accounts department of the company has stated that financial options would help the company to manage the employee stock option plans. However, no one at Triple A is familiar with the basics of financial options. You were asked to prepare a brief presentation that the firm’s executives could use to gain a cursory understanding of financial options.

During the presentation, one board member, Brittany Waite asked the following questions:

1. What is the difference between a call option and a put option?

2. Under what circumstances can an investor buy a call option or a put option?

3. I heard that American options are issued in the United States and European options are issued in Europe. How correct is this statement?

4. Can you explain the difference between covered call options and naked call options?

5. Another board member, Gang Zhou stated that financial options have a lot of unique set of terminology that are very confusing. He wants you to explain these terms:

i. in-the-money

ii. out-of-the money

iii. at-the-money

iii. Long-term Equity Anticipation Security (LEAPS)

6. For demonstration purposes you decided to use the binomial option pricing to find the price of a call option of the company’s stock. The current price of the stock is $40. In 1 year, you expect the price of the stock to be either $60 or $30. The annual risk-free rate is 5%. Calculate the price of the call option if the exercise price of the stock is $42 and expires in 1 year. (Use daily compounding).

7. The CEO of the company asked you to address the factors that can affect the prices of call options of the company. List five factors that can affect call option prices.

8. Describe four ways that option pricing can be used to help Triple A in its corporate financial management.

Submit your answers in a Word document.