Joel Franklin is a portfolio manager responsible for derivatives. Franklin observes an American-style option and a European-style option with the same strike price, expiration, and underlying stock. Franklin believes that the European-style option will have a higher premium than the American-style option.

a. Critique Franklin’s belief that the European-style option will have a higher premium. Franklin is asked to value a 1-year European-style call option for Abaco Ltd. common stock, which last traded at $43.00. He has collected the information in the following table.

Closing stock price ...............$43.00

Call and put option exercise price .......... 45.00

1-year put option price .............. 4.00

1-year Treasury bill rate ............... 5.50%

Time to expiration .................One year

b. Calculate, using put-call parity and the information provided in the table, the European-style call option value.

c. State the effect, if any, of each of the following three variables on the value of a call option.

i. An increase in short-term interest rate.

ii. An increase in stock price volatility.

iii. A decrease in time to option expiration.