The exercise price on one of ORNE Corporation\'s call options is $25 and the pri

Question

The exercise price on one of ORNE Corporation's call options is $25 and the price of the underlying stock is $29. The option will expire in 35 days and is currently selling at $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? c. If the price of the underlying stock changes to $33 per share, will the market value of the option increase, decrease, or remain the same? Why d. If Orne Corporation had issued a put option (instead of the call), would its value increase, decrease, or remain the same if the price of the underlying stock increased? Why?

Explanation / Answer

Part a:

The value of the option can be calculated with the use of following formula:

Value of Call Option = Stock Price - Exercise Price

_________

Using the values provided in the question, we get,

Option Value = 29 - 25 = 4

The significance of this value is that it helps in determining as to whether the option will be exercised by the investor or not. Since the option value is positive, the investor would prefer to exercise the option and buy shares at a lower price of $25 and sell at a higher value of $29.

________

Part b)

The investor would willing to pay more because the call option so bought can be sold at a premium value in the near future, thereby, providing an opportunity to earn more profits.

________

Part c)

If the price of the underlying stock changes to $33, the value of the option would be 8 (33 - 25 = -8). As a result, the market value will not increase. It is so because, the exercise price of the option ($25) is still lower than the stock price ($33) of the option, thereby, providing an opportunity to buy at at a lower price of $25.

________

Part d)

In case of a put option, the value of the option can be calculated with the use of following formula:

Value of Put Option = Exercise Price - Stock Price

_________

Using the values provided in the question, we get,

Option Value = 25 - 29 = -4 or 0

The market value will remain at the same level. It is so because, the exercise price of the option ($25) is lower than the stock price ($29) of the option, which would mean that the investor would not exercise the put option.

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