2. Michael Weber, CFA, is analyzing several aspects of option valuation, including the determinants of the value of an option, the characteristics of various models used to value options, and the potential for divergence of calculated option values from observed market prices.

a. What is the expected effect on the value of a call option on common stock if the volatility of the underlying stock price decreases? If the time to expiration of the option increases?

b. Using the Black-Scholes option-pricing model, Weber calculates the price of a 3-month call option and notices the option’s calculated value is different from its market price. With respect to Weber’s use of the Black-Scholes option-pricing model, i. Discuss why the calculated value of an out-of-the-money European option may differ from its market price.

ii. Discuss why the calculated value of an American option may differ from its market price.