The Market Price of an Option Is a Function Of

question 9

Multiple Choice

The market price of an option is a function of:

• A)market expectations regarding the medium term dividend stream expected on the shares underlying the option.Where the exercise price is expected to be greater than the sum of 2 to 3 years' dividends the option will sell at a discount.Where the exercise price is less than 1 year's expected dividend it will sell at a premium.
• B)the difference between the market price of the share and the exercise price on the option.The market price of the option will, however, be greater than this difference where the option does not expire for some time.All other things being equal, the greater the time until the option is to be exercised the greater the difference will be between the price of the option and the difference between the exercise price and the share price.
• C)the liquidity of the shares underlying the options.Investors in the market are more interested in options over shares that are subsequently easily traded.A measure of the liquidity of a share is the average volume of shares turned over during a period.The higher this measure, the higher the market price of the option.
• D)the market price as being closely linked to the exercise price and where it does not vary significantly from that.The only situation in which this ceases to be true is when significant impacts on the whole market shift the prices of many shares down at once (for example, in the case of a major impact to a whole economy such as was experienced in 2007 when the global financial crisis started).

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Definitions:

Cash Flow

The combined value of financial transactions into and out of an enterprise, crucially affecting its cash reserves.

Present Value

is the current worth of a future sum of money or stream of cash flows given a specified rate of return.

Discount Rate

The rate of interest utilized to calculate the current value of future cash flows in a discounted cash flow assessment.

Incremental Net Income

The additional net income that results from a specific business decision compared to an alternative.