Reading 64: LOS g ～ Q1- 3

1.Dividends on a stock can be incorporated into the valuation model of an option on the stock by:

A)   subtracting the future value of the dividend from the current stock price.

B)   adding the future value of the dividend to the option value.

C)   subtracting the present value of the dividend from the current stock price.

D)   adding the present value of the dividend to the current stock price.

The correct answer was C)

The option pricing formulas can be adjusted for dividends by subtracting the present value of the expected dividend(s) from the current asset price.

2.Compared to the value of a call option on a stock with no dividends, a call option on an identical stock expected to pay a dividend during the term of the option will have a:

A)   lower value in all cases.

B)   lower value only if it is an American style option.

C)   higher value in all cases.

D)   higher value only if it is an American style option.

The correct answer was A)

An expected dividend during the term of an option will decrease the value of a call option.

3.The value of a put option will be higher if, all else equal, the:

A)   underlying asset has less volatility.

B)   exercise price is lower.

C)   stock price is higher.

D)   underlying asset has positive cash flows.

The correct answer was D)

Positive cash flows in the form of dividends will lower the price of the stock making it closer to being "in the money" which increases the value of the option as the stock price gets closer to the strike price.