Chapter 5, Problem 1Q

Define each of the following terms:

1. a. Option; call option; put option
2. b. Exercise value; strike price
3. c. Black-Scholes option pricing model

Summary Introduction

To discuss: Option, put option and call option

Explanation of Solution

Call option is an option to purchase or buy a specific number of shares of security within a future period.

Put option is an option to sell a specific number of shares of security within a future period.

The option contract’s market price is termed as the option price.

Summary Introduction

To discuss: The term exercise value and strike price

Explanation of Solution

Exercise value is a value of a call option where it is exercised today. It is the value of current stock price minus the strike price.

Strike price is a price which is stated in the option contract. It is the price the securities are bought and sold.

Summary Introduction

To discuss: The Black-Scholes option pricing model

Explanation of Solution

This model is used by option traders mainly to value the options. It is derived through a concept of riskless hedge.

By purchasing shares of a stock and selling the call option on the stock simultaneously will create a risk-free investment. This return should equal the arbitrage opportunity or risk-free rate will exist.