Master CFA Institute CFA-Level-II Exam with Reliable Practice Questions
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Stan Loper is unfamiliar with the Black-Scholes-Merton (BSM) option pricing model and plans to use a two-period binomial model to value some call options. The stock of Arbor Industries pays no dividends and currently trades for $45. The up-move factor for the stock is 1.15, and the risk-free rate is 4%. He is considering buying two-period European style options on Arbor Industries with a strike price of S40. The delta of these options over the first period is 0.83.
Loper is curious about the effect of time on the value of the calls in the binomial model, so he also calculates the value of a one-period European style call option with a strike price of 40.
Loper is also interested in using the BSM model to price European and American call and put options. He is concerned, however, whether the assumptions necessary to derive the model are realistic. The assumptions he is particularly concerned about are:
* The volatility of the option value is known and constant.
* Stock prices are lognormally distributed.
* The continuous risk-free rate is known and constant.
Loper would also like to value options on Rapid Repair, Inc., common stock, but Rapid pays dividends, so Loper is uncertain what the effect will be on the value of the options. Loper uses the two-period model to value long positions in the Rapid Repair call and put options without accounting for the fact that Rapid Repair pays common dividends.
The difference in value between the European 40 calls and otherwise identical American 40 calls is closest to:
Correct : B
The possibility of early exercise is not valuable for call options on non-dividend paying stocks, so the value of the American call is the same as the value of the European call, and the difference in value is zero. (Study Session 17, LOS 60.b)
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Stan Loper is unfamiliar with the Black-Scholes-Merton (BSM) option pricing model and plans to use a two-period binomial model to value some call options. The stock of Arbor Industries pays no dividends and currently trades for $45. The up-move factor for the stock is 1.15, and the risk-free rate is 4%. He is considering buying two-period European style options on Arbor Industries with a strike price of S40. The delta of these options over the first period is 0.83.
Loper is curious about the effect of time on the value of the calls in the binomial model, so he also calculates the value of a one-period European style call option with a strike price of 40.
Loper is also interested in using the BSM model to price European and American call and put options. He is concerned, however, whether the assumptions necessary to derive the model are realistic. The assumptions he is particularly concerned about are:
* The volatility of the option value is known and constant.
* Stock prices are lognormally distributed.
* The continuous risk-free rate is known and constant.
Loper would also like to value options on Rapid Repair, Inc., common stock, but Rapid pays dividends, so Loper is uncertain what the effect will be on the value of the options. Loper uses the two-period model to value long positions in the Rapid Repair call and put options without accounting for the fact that Rapid Repair pays common dividends.
Are the BSM assumptions listed correctly?
Correct : C
The first assumption lisced in the vignette should read, 'The volatility of the return on the underlying stock is known and constant.' The other listed assumptions are correct. (Study Session 17, LOS 60.c)
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Stan Loper is unfamiliar with the Black-Scholes-Merton (BSM) option pricing model and plans to use a two-period binomial model to value some call options. The stock of Arbor Industries pays no dividends and currently trades for $45. The up-move factor for the stock is 1.15, and the risk-free rate is 4%. He is considering buying two-period European style options on Arbor Industries with a strike price of S40. The delta of these options over the first period is 0.83.
Loper is curious about the effect of time on the value of the calls in the binomial model, so he also calculates the value of a one-period European style call option with a strike price of 40.
Loper is also interested in using the BSM model to price European and American call and put options. He is concerned, however, whether the assumptions necessary to derive the model are realistic. The assumptions he is particularly concerned about are:
* The volatility of the option value is known and constant.
* Stock prices are lognormally distributed.
* The continuous risk-free rate is known and constant.
Loper would also like to value options on Rapid Repair, Inc., common stock, but Rapid pays dividends, so Loper is uncertain what the effect will be on the value of the options. Loper uses the two-period model to value long positions in the Rapid Repair call and put options without accounting for the fact that Rapid Repair pays common dividends.
When Loper failed to account for Rapid Repair dividends, did he likely overvalue the calls or the puts?
Correct : B
Dividends on rhe underlying stock decrease the value of call options and increase the value of put options, all else equal. By ignoring them in his valuation, Loper will likely overvalue a long call option and undervalue a long put. (Study Session 17, LOS 60.g)
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Charles Mabry manages a portfolio of equity investments heavily concentrated in the biotech industry. He just returned from an annual meeting among leading biotech analysts in San Francisco. Mabry and other industry experts agree that the latest industry volatility is a result of questionable product safety testing methodologies. While no firms in the industry have escaped the public attention brought on by the questionable safety testing, one company in particular is expected to receive further attention---Biological Instruments Corporation (BIC), one of several long biotech positions in Mabry's portfolio. Several regulatory agencies as well as public interest groups have heavily criticized the rigor of BIC's product safety testing.
In an effort to manage the risk associated with BIC, Mabry has decided to allocate a portion of his portfolio to options on BIC's common stock. After surveying the derivatives market, Mabry has identified the following European options on BIC common stock:
Mabry wants to hedge the large BIC equity position in his portfolio, which closed yesterday (June 1) at $42 per share. Since Mabry is relatively inexperienced with utilizing derivatives in his portfolios, Mabry enlists the help of an analyst from another firm, James Grimell.
Mabry and Grimell arrange a meeting in Boston where Mabry discusses his expectations regarding the future returns of BIC's equity. Mabry expects BIC equity to make a recovery from the intense market scrutiny but wants to provide his portfolio with a hedge in case BIC has a negative surprise. Grimell makes the following suggestion:
"If you want to avoid selling the BIC position and are willing to earn only the risk-free rate of return, you should sell calls and buy puts on BIC stock with the same market premium. Alternatively, you could buy put options to manage the risk of your portfolio. I recommend waiting until the vega on the options rises, making them less attractive and cheaper to purchase."
Which of the following statements regarding the delta of the BIC options is correct? (Assume that the largest delta is defined as the delta furthest from zero)
Correct : C
An option that is deep in-the-money will have the largest delta. Call options that are deep in-the-money will have a delta close to one, while put options that are deep in-the-money will have a delta close to -1. Options that are out-of-the-money will have deltas close to zero. Put F is the option that is deepest in-the-money, and therefore has the largest delta (even though it is negative, the change in the price of Put F given a change in the price of BIC stock will be larger than any of the other options). Call C is the deepest out-of-the-money option, and thus has the smallest delta. (Study Session 17, LOS 60.e)
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Lauren Jacobs, CFA, is an equity analyst for DF Investments. She is evaluating Iron Parts Inc. Iron Parts is a manufacturer of interior systems and components for automobiles. The company is the world's second largest original equipment auto parts supplier, with a market capitalization of $1.8 billion. Based on Iron Parts's low price-to-book value ratio of 0.9* and low price-to-sales ratio of 0.15x, Jacobs believes the stock could be an interesting investment. However, she wants to review the disclosures found in the company's financial footnotes. In particular, Jacobs is concerned about Iron Parts's defined benefit pension plan. The following information for 2007 and 2008 is provided.
Iron Parts has adopted SFAS No. 158, Employers' Accounting for Defined Benefit Pensions and Other Postretirement Plans.
Jacobs wants to fully understand the impact of changing pension assumptions on Iron Parts's balance sheet and income statement. In addition, she would like to compute Iron Parts's economic pension expense.
As of December 31, 2008, the funded status of Iron Parts's pension plan was:
Correct : B
Funded status equals fair value of plan assets minus PBO (395 - 635 = -240). (Study Session 6, LOS 22.c,f)
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