finance question

After reading the case, please answer the following questions. Clearly show your work (you do not need to type the computations). For the questions involving the use of the Black Sholes pricing model you can use the provided Excel worksheet – provide the answers inside the main document and also provide the Excel file with the solutions (I want to see the inputs).

Questions:

1. What is distinctive about an option security? Can calls and puts be valued using the traditional discounted cash flow model (DCF) model? Why or why not?

2. Consider the Medco call option with a $40 exercise price and an October expiration. Using the riskless hedge approach and monthly binomial trials what is this option worth today?

In order to build the binomial tree, you need to estimate the volatility for Medco. Using the stock prices provided in the excel file, follow these steps:

a. Compute daily return for each trading day using adjusted prices as follows:

b. Find the standard deviation of daily returns over the past year.

c. To annualize the standard deviation, take the standard deviation of daily return and multiply by the square root of 260 (the approximate number of trading days in one year).

3. Now consider the Medco call option with an exercise price of $40 and a January expiration. Using the riskless hedge approach and monthly binomial trials, what is the option worth today? How do you explain the difference between values for the October and January calls?

4. What is the value of the Medco call option with a $40 exercise price and an October expiration using the Black Scholes option pricing model? Why does this value differ from the value using the binomial approach?

5. Let us now turn to the AstraZeneca call option with a $40 exercise price and an October expiration. Using the riskless hedge binomial approach and the Black Sholes option pricing model, what is this option worth? For now, disregard the dividend AZN is expected to pay in September. How does this value compare to the MHS call with same contract terms? What accounts for the difference?

6. Returning to the AstraZeneca call option with a $40 exercise price and an October expiration, how do you expect the September dividend to affect the valuation? Why? Use the Black Sholes option pricing model to validate your prediction. Assume that the 2008 dividend amount and timing will be identical to that of 2007. Are there any problems using the Black Scholes model to value an option on a dividend-paying stock?