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9.6. A company declares a 4-for-1 stock split. Explain how the terms change for a call option

with a strike price of $60. 2%

The strike price is reduced to $15, and the option gives the holder the right to purchase 4 times as many shares.

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9.7. ‘‘Employee stock options are different from regular exchange-traded stock options

because they can change the company’s capital structure.’’ Explain this statement.

The exercise of employee stock options usually leads to new shares being issued by thecompany and sold to the employee. This changes the amount of equity in the capitalstructure. When a regular exchange-traded option is exercised no new shares are issued andthe company’s capital structure is not affected

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10.2. What is a lower bound for the price of a four-month call option on a non-dividendpaying

stock when the stock price is $28, the strike price is $25, and the risk-free interest

rate is 8% per annum


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11.1. What is meant by a protective put? What position in call options is equivalent to a

protective put 2%

A protective put consists of a long position in a put option combined with a long position

in the underlying shares. It is equivalent to a long position in a call option plus a certain

amount of cash. This follows from put–call parity:

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11.2. Explain two ways in which a bear spread can be created. 4%

A bear spread can be created using two call options with the same maturity and different

strike prices. The investor shorts the call option with the lower strike price and buys the call

option with the higher strike price. A bear spread can also be created using two put options

with the same maturity and different strike prices. In this case, the investor shorts the put

option with the lower strike price and buys the put option with the higher strike price

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11.3. When is it appropriate for an investor to purchase a butterfly spread? 2%

A butterfly spread involves a position in options with three different strike prices (K1, K2,

and K3). A butterfly spread should be purchased when the investor considers that the

price of the underlying stock is likely to stay close to the central strike price, K2.

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8.2. Explain what is meant by subprime mogage an ABS an ABS CDO 6%

A subprime mortgage is a mortgage where the risk of default is higher than normal.

An ABS is a set of tranches created from a portfolio of morgages or other assets An ABS CDO is an ABS created from particular tranches of a number of diferent abs

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8.10 What is meant by the term agency cost? How did agency costs play a role in the credit crisis? 4%

Agency cost is a term used to describe the costs in a situation where the interests of two parties are not perfectly aligned. There were potential agency costs between the originators of mortgages and investors. And employees of banks who earned bonuses and the banks themselves.