Corporate Finance - Chap 23 - Options, Future: Basic Concepts

The calculation should be handwritten or using a word doc.

DONT WORK ON EXCEL SHEET PLEASE

MINICASE

Clissold Industries Options

You are currently working for Clissold Industries. The company, which went public five years ago, designs, produces, and distributes lighting equipment and specialty products worldwide. Because of recent events, Mal Clissold, the company president, is concerned about the companys risk, so he asks for your input.

In your discussion with Mal, you explain that the capital asset pricing model (CAPM) proposes that the market risk of the companys stock is the determinant of its expected return. Even though Mal agrees with this, he argues that his portfolio consists entirely of Clissold Industry stock and options, so he is concerned with the total risk, or standard deviation, of the companys stock. Furthermore, even though he has calculated the standard deviation of the companys stock for the past five years, he would like an estimate of the stocks future volatility.

Mal states that you can find the estimated volatility of the stock for future periods by calculating the implied standard deviation of option contracts on the company stock. When you examine the factors that affect the price of an option, all of the factors except the standard deviation of the stock are directly observable in the market. Mal states that because you can observe all of the option factors except the standard deviation, you can simply solve the BlackScholes model and find the implied standard deviation.

To help you find the implied standard deviation of the companys stock, Mal has provided you with the following option prices on four call options that expire in six months. The risk-free rate is 4 percent, and the current stock price is $68:

Strike price Option price

$65 $18.73

$70 $15.69

$75 $11.06

$80 $7.36

1. How many different volatilities would you expect to see for the stock?

2. Unfortunately, solving for the implied standard deviation is not as easy as Mal suggests. In fact, there is no direct solution for the standard deviation of the stock even if we have all the other variables for the BlackScholes model. Mal would still like you to estimate the implied standard deviation of the stock. To do this, set up a spreadsheet using the Solver function in Microsoft Excel to calculate the implied volatility for each of the options.

3. Are all of the implied volatilities for the options the same? (Hint: No.) What are the possible reasons that can cause different volatilities for these options?

4. After you discuss the importance of volatility on option prices, your boss mentions that he has heard of the VIX. What is the VIX and what does it represent? You might need to visit the Chicago Board Options Exchange (CBOE) at www.cboe.com to help with your answer.

5. When you are on the CBOE website, look for the option quotes for the VIX. What does the implied volatility of a VIX option represent?