NORREL Corporation\'s stock is selling for $35 per share. An investor is conside
ID: 2384116 • Letter: N
Question
NORREL Corporation's stock is selling for $35 per share. An investor is considering buying a call option with an exercise price of $40. The investor is willing to pay the premium of 50 cents per option.
a. Calculate the exercise value of the option?
b. Why is an investor willing to pay 50 cents an option when the stock is going for $35?
c. Calculate the exercise value if the price of the stock increases to $42 per share.
d. If the exercise price for both the call option and the put option is $40, which will have a higher premium if the underlying stock price falls to $30 per share? Why?
Explanation / Answer
Solution-a
The exercise value of the option is $40.
Solution-b
There may be few possible reasons for this. One reason is that the investor probably does not have enough money to purchase the company's stock at present. He might be expecting some cash receipts upon maturity of certain investments which would match with the exercise date of the call option. Hence, he must have decided to purchase at the date when he has sufficient funds. Secondly, the investor must have had other profitable options right now than this and hence he might have decided to shift this investment for a future period. Also, he must have expected that the company's stock price would go up and that he can make sufficient profits despite paying call premium and delaying of purchase. Apart from this, if there is uncertainty in the rise of stock price, the investor would be willing to shift the purchase. He must have decided to buy the shares at a later date in case if the stock price rises and he can sell it earning a considerable margin. This is because call option only gives the right to buy at a certain date at a specified price, but there is no obligation on the part of the buyer of the option to purchase the securities.
Solution-c
If the stock price increases to $42 per share, the exercise value would still be $40 per share if it is before or on the specified contract date.This is because the call option grants the right to purchase a certain quantity of securities at a specified price upto a specified date.
Solution-d
The put option will have a higher premium if the stock price falls to $30 per share. This is because the margin expected is higher in selling the shares.
The put option gives the buyer the right to sell the stock at a certain date at $40, when he can buy the shares now for a lower price of $30. Also, it is not worth to buy a call option for $40 when the stock is now selling for $30, unless and until huge profits can be expected and when there is acute shortage of funds.
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