Markets Discussion Due on September 7. A hard copy of one page double space writ

Question

Markets Discussion Due on September 7. A hard copy of one page double space write up is due in class on September 6 (Wedngsday). 1) What are the effects of a stock split on a call option written against the stock? Put option? Give a numerical example 2) In general, what are the effects of a cash dividends on the price of a call option written against the stock? Will the exercise price of the call option be adjusted to compensate the holders of t call option for their loss? Expand All Collaps 20 % 1 of 5 topics complete Chapter 9 Notes- -Options Markets Link 0

Explanation / Answer

1.

An options contract undergoes an adjustment called "being made whole" when the underlying stock splits.
Being made whole" means the options contact is modified so that the holder is neither negatively nor positively affected by the corporate action. While a stock split adjusts the price of an option's underlying security, the contract is adjusted so that any changes in price due to the split do not affect the value of the option. If your option is purchased post-split (i.e. after the split is announced), it will not be adjusted because it already reflects the post-split price of the underlying security.

For example, you buy a call option that controls 100 shares of XYZ with a strike price of $75. if XYZ announces a 2: 1 stock split, the contract would now control 200 shares with a strike price of $37.50. On the other hand, if the stock split 3 for 2, the option would control 150 shares with a strike price of $50.

2.Cash dividends affect option prices through their effect on the underlying stock price. Because the stock price is expected to drop by the amount of the dividend on the ex-dividend date, high cash dividends imply lower call premiums and higher put premiums.

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