Explanation:
DIV and SCK are identical with the exception that DIV pays a dividend. Recall that when a stock pays a dividend, the stock’s value must decrease by the amount of the dividend, which in turn will increase the value of a put option and decrease the value of a call option. All else being equal, the payment of a dividend will reduce the lower pricing bound for a call option, which means the value of the lower pricing bound for DIV’s call options will be smaller than the lower pricing bound for SCK’s call options. When the dividend is large enough, American calls might be optimally exercised early if the amount of the dividend exceeds the amount of interest that is forgone as a result of the early exercise. Since the dividend yield is 2%, and the current risk-free interest rate is 1.5%, it makes sense to exercise American call options on DIV before expiration.
(Book 3, Module 39.2, LO 39.b)
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Question 39
A derivatives trader is reviewing the option pricing bounds for put and call options on two stocks in a report for her supervisor:
$60, and the options the trader is reviewing both have a strike price of $55 and six months until expiration. SCK does not pay any dividends.$60, and the options the trader is reviewing both have a strike price of $55 and six months until expiration. DIV pays a 2% annualized dividend to its shareholders, payable quarterly.Upon reading the trader's report, her supervisor asks her to review her statements because they are not all accurate. Which of the trader's statements is correct?
A
The value of the lower pricing bound for DIV’s call options will be smaller than the lower pricing bound for SCK’s call options.
B
With a current risk-free interest rate of 1.5%, it makes sense not to exercise the American call options on DIV before expiration.
C
When a stock pays a dividend, the stock’s value must increase by the amount of the dividend, which in turn will decrease the value of a put option and increase the value of a call option.
D
When a dividend is small enough, American calls might be optimally exercised early if the amount of the dividend is less than the amount of interest that is forgone as a result of the early exercise.
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