Joel Franklin is a portfolio manager responsible for derivatives. Franklin observes an American-style option and a European-style option with the same strike price, expiration, and underlying stock. Franklin believes that the European-style option will have a higher premium than the American-style option.
a. Critique Franklin's belief that the European-style option will have a higher premium. Franklin is asked to value a one-year European-style call option for Abaco Ltd. common stock, which last traded at $43.00. He has collected the following information:
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Closing stock price
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$43.00
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Call and put option exercise price
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$45.00
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One-year put option price
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$ 4.00
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One-year Treasury bill rate
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5.50%
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Time to expiration
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One year
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b. Calculate, using put-call parity and the information provided, the European-style call option value.
c. State the effect, if any, of each of the following three variables on the value of a call option: (1) an increase in short-term interest rate, (2) an increase in stock price volatility, and (3) a decrease in time to option expiration.