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Chapter 5: Q21I (page 515)

An executive compensation scheme might provide a manager a bonus of $1,000 for every dollar by which the company’s stock price exceeds some cut off level. In what way is this arrangement equivalent to issuing the manager calls options on the firm’s stock?

Short Answer

Expert verified

Like payoff in call option, the executive receives a bonus on stock price if it exceeds a certain value or receives nothing, if price fall or remain constant.

Step by step solution

01

Definition of call option

A call option gives the option to buyer to buy an underlying asset at a specified price and time.

02

Explanation on equivalent arrangement to issuing the call option

A call option holder earns a profit when the securities price goes above the strike price. Similarly, the manager will earn a bonus of $1,000 when the price exceeds some cut-off level; therefore, this arrangement is equivalent to the call option.

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Most popular questions from this chapter

a. A butterfly spread is the purchase of one call at exercise price X 1, the sale of two calls at exercise price X 2 , and the purchase of one call at exercise price X 3 . X 1 is less than X 2 , and X 2 is less than X 3 by equal amounts, and all calls have the same expiration date. Graph the payoff diagram to this strategy.

b. A vertical combination is the purchase of a call with exercise price X 2 and a put with exercise price X 1, with X 2 greater than X 1 . Graph the payoff to this strategy.

You purchase a Treasury-bond futures contract with an initial margin requirement of 15% and a futures price of \(115,098. The contract is traded on a \)100,000 underlying par value bond. If the futures price falls to $108,000, what will be the percentage loss on your position?

Return to Problem 37. What will be the payoff to the put, Pu, if the stock goes up?

What will be the payoff, Pd, if the stock price falls? Value the put option using the riskneutralshortcut described in the box on page 533. Confirm that your answer matchesthe value you get using the two-state approach.

A one-year gold futures contract is selling for \(1,641. Spot gold prices are \)1,700 and the one-year risk-free rate is 2%. What arbitrage opportunity is available to investors? What strategy should they use, and what will be the profits on the strategy?

All else being equal, is a put option on a high-beta stock worth more than one on a lowbetastock? The firms have identical firm-specific risk.
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