Which of the following statements are true:

Which of the following statements are true:

I. A deep in-the-money call option has a value very close to that of a forward contract with a forward price equal to the exercise price

II. If the volatility of a stock goes down to zero, the value of a call option on the stock will tend to be close to that of a forward contract so long as the option is in the money.

III. All other things remaining the same, the issue of stock warrants exercisable at a future date will cause a decline in the current stock price

IV. Implied volatilities are calculated from market prices of options and are forward looking
A . I and IV
B . II and III
C . III and IV
D . All of the above

View Answer

Answer: D

Explanation:

All the statements are correct, therefore Choice ‘d’ is the correct answer. Let us look at each of these statements one by one.

I. A deep in-the-money call option has a value very close to that of a forward contract with a forward price equal to the exercise price. This is true because a deep in the money call option is most likely to be exercised, and is therefore effectively like a forward contract to buy the stock at the exercise price.

We can also look at this using the BSM formula for a call option. If c be the value of a call option, and all other variables have their usual meaning (S0 is the spot price, K is exercise price, and t is time to expiry), then according to the Black Scholes model the value of a call is given by the following expression: