Assume the stock of Dismal Seepage Waste Disposal Co. can be at any of the follo

Question

Assume the stock of Dismal Seepage Waste Disposal Co. can be at any of the following prices on June 1, with the associated probabilities as shown:

Price

Prob.

$10

.4

$15

.3

$20

.2

$25

.1

What is the expected value (EV) of Dismal Seepage stock? Show your calculations.

What will be the price of a put with a strike price of $20 which expires on June 1? Show your calculations.

Explain why increased volatility in the price of the underlying stock increases the price of an option on that stock.

Price

Prob.

$10

.4

$15

.3

$20

.2

$25

.1

Explanation / Answer

The expected value (EV) of Dismal Seepage stock Price Prob. Price*Prob. 10 0.4 4 15 0.3 4.5 20 0.2 4 25 0.1 2.5 Expected value of 15 Price of the put option=20-15= $ 5 The degree to which a stock price fluctuates is called its volatility. Both call and put options are affected due to this volatility. Higher volatility raises the premim of the options cosequent to higher risk to the seller.

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