OPTIONSPROBLEMS

1. Will the following events increase, decrease, or have no effect on the premium of a call option on company's stock.

a.Microsoft announces a large special dividend.

b.AbbVie issues a large amount of new stock.

c.McDonalds uses its cash for a large stock buyback.

d.Biopharmaceutical company AstraZeneca sells its stable dental supply unit and invests the proceeds in biotech research.

2. Suppose you face the following situation.You have saved $20,000 for next years tuition ($14,000) and expenses ($6,000) in a bank account earning 5%.But you now see an opportunity to do more with the money during the month between now and the start of the next semester.You are convinced that Electric Arts which sells for $20 per share is a great buy, however, you can't afford to have less than $18,000 by next month or you won't be able to pay for enough courses to graduate (you'll eat a lot of spaghetti and save $2000 in expenses if you have to).Given this setting, note the good and bad points of each of the strategies below.Which of the potential strategies below is the best alternative?

a.You buy 1000 shares.

b.You buy 1000 shares and sell 10 call option contracts, each with a strike price of $25 and a premium of $5.

c.You buy 10 call option contracts each with a strike price of $27 and a premium of $2.

d.You buy 1000 shares and sell 10 call option contracts, each with a strike price of $25 and a premium of $5 and buy 10 put option contracts, each with a strike price of $18 and a premium of $5.

3. Answer the questions below in light of what you know about options.

1. You are a mutual fund manager at the Happy Fund. You will receive a bonus of $10,000, for each percentage by which Happy Fund's return exceeds that of the S&P 500. If Happy Fund does worse than the S&P 500 you receive no bonus. As the manager of the fund, how can you increase the value of this bonus provision without necessarily working harder?

1. The Toro snowblower dealer offers the following deal. If it does not snow more than 10 inches this winter, customers can return the snowblower for a full refund. Suppose you work at Toro and your job is to decide how to price snowblowers given this type of deal. Briefly explain how you would figure out how much to add to the price to cover the refund policy?

1. You want to buy a new home with a current price of $400,000. You tell the builder you won't buy now because you are worried that the home price will fall during the next year. The builder offers you the following deal. You will pay $410,000 for the house instead of $400,000. In one year, the home will be appraised by an independent appraiser. If the value falls below $400,000 he will pay the difference between $400,000 and the appraised value. How would you decide whether this is a good deal or not?

4. You have a cancer drug project that requires a $10 million investment. The project will provide cash flows with present value of $8 million when considered alone. However, you estimate that if you make the investment in the first cancer drug, you will be able to develop a second improved cancer drug in two years, and the option to do that is worth $5.3 million.

a. Should you accept the project?

b. Suppose the first cancer drug project can be delayed one year but you lose the chance to develop the second drug. If the option to delay the project is worth $3 million, should you accept the project now or wait?

c. How about if you do not lose the chance to do the second project if you delay the first one?