Corporate Finance, 3e (Berk/DeMarzo) Chapter 21 Option Valuation
21.1 The Binomial Option Pricing Model
1) Which of the following statements is FALSE?
A) A replicating portfolio is a portfolio of other securities that has exactly the same value in one period as the option.
B) By using the Law of One Price, we are able to solve for the price of the option as long as we know the probabilities of the states in the binomial tree.
C) The binomial tree contains all the information we currently know: the value of the stock, bond, and call options in each state in one period, as well as the price of the stock and bond today. D) The idea that you can replicate the option payoff by dynamically trading in a portfolio of the underlying stock and a risk-free bond was one of the most important contributions of the original Black-Scholes paper. Today, this kind of replication strategy is called a dynamic trading strategy. Answer: B
Explanation: B) By using the Law of One Price, we are able to solve for the price of the option without knowing the probabilities of the states in the binomial tree. Diff: 2
Section: 21.1 The Binomial Option Pricing Model Skill: Conceptual
2) Which of the following statements is FALSE?
A) The techniques of the binomial option pricing model are specific to European call and put options.
B) We can summarize the payoffs for the Binomial Option Pricing Model in a binomial tree—a timeline with two branches at every date that represent the possible events that could happen at those times.
C) We define the state in which the stock price goes up as the up state and the state in which the stock price goes down as the down state.
D) When using the Binomial Option Pricing Model, by the Law of One Price, the price of the option today must equal the current market value of the replicating portfolio. Answer: A Diff: 2
Section: 21.1 The Binomial Option Pricing Model Skill: Conceptual
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3) Consider the following equation: D =
In this equation, the term D, represents:
A) the change in the stock price from the low state to the high state. B) the sensitivity of the option's value to changes in the stock price. C) the position in bonds for the replicating portfolio.
D) the change in the stock price from the high state to the low state. Answer: B Diff: 2
Section: 21.1 The Binomial Option Pricing Model Skill: Conceptual
4) Consider the following equation: B =
In this equation, the term B, represents: A) the bid price for the option.
B) the position in bonds for the replicating portfolio.
C) the highest price at which it is advantageous to buy the option. D) the number of shares of stock to buy for the replicating portfolio. Answer: B Diff: 2
Section: 21.1 The Binomial Option Pricing Model Skill: Conceptual
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Copyright ? 2014 Pearson Education, Inc.
Use the information for the question(s) below.
The current price of KD Industries stock is $20. In the next year the stock price will either go up by 20% or go down by 20%. KD pays no dividends. The one year risk-free rate is 5% and will remain constant.
5) Using the binomial pricing model, the calculated price of a one-year call option on KD stock with a strike price of $20 is closest to: A) $2.40 B) $2.00 C) $2.15 D) $1.45 Answer: A
Explanation: A)
D = B =
= =
= .5
= -7.619048
C = SD + B = $20(.5) + (-7.618048) = $2.38 Diff: 2
Section: 21.1 The Binomial Option Pricing Model Skill: Analytical
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