The exercise price on one of ORNE Corporation\'s call options is $20 and the pri
ID: 2687354 • Letter: T
Question
The exercise price on one of ORNE Corporation's call options is $20 and the price of the underlying stock is $25. The option will expire in 25 days. The option is currently selling for $5.50. a. Calculate the option's exercise value? What is the significance of this value? b. Why is an investor willing to pay more than the exercise value for the option? If the price of the underlying stock changes to $30 per share, will the market value of the option increase, decrease, or remain the same? Why? d. If the option were a put option, would its value increase, decrease, or remain the same if the price of the underlying stock climbs? Why?Explanation / Answer
(a) Option exercise value = Price of underlying Stock - Exercise Price of Option = $25 - $20 = $5
Thus, Option exercise value = $5. The significance of this value is that the option holder (the person who has a "long" position on the Call) has an "option" to buy the stock at an amount - the exercise price - which is lower than the market value of the stock.
(b) The investor is willing to pay more than the exercise value, i.e. the price of the Call option is $5.50 (and not the exact $5 calculated above) because of this privilege of holding the call option, i.e. the right to buy the stock at a price less than the market value of the stock. If this premium weren't charged, then the option would not be offered by the party selling the option (the underwriter who is "short" position on the Call option also needs to make a profit, in order to offer this service)
(c) If the price of the underlying stock increases to $30 per share, the market value of the option will increase to
Option exercise value = $30 - $20 = $10. This is because as the underlying stock increases in price in the stock market, the call holder still has the "option" to buy the stock at the same exercise price of $20. So he/she can effectively own the asset for much cheaper than its market value.
(d) If the option were a Put option, the reverse would be true. As the price of the underlying stock increases, the Option exercise value (the payoff) decreases. The Put holder would be better off selling the stock in the open market (the stock market) than exercising a Put option to sell it for a loss at $20 (in practice, no rational investor would ever do this). So the value of a Put option always decreases as the price of the underlying security increases.
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