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ECON435 > 21: Option Valuation > Flashcards

21: Option Valuation Flashcards

1
Q

Intrinsic Value Definition

A

The present value of a firm’s expected future net cash flows discounted by the required rate of return.

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2
Q

Time Value Definition

A

The part of the value of an option that is due to positive time to expiration.

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3
Q

Binomial Model Definition

A

An option valuation model predicted using the assumption that the stock price can move to only two values over a short time period.

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4
Q

Black-Scholes Pricing Formula

A

An equation to value a call option.

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5
Q

Implied Volatility Definition

A

The standard deviation of stock returns that is consistent with an option’s market value.

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6
Q

Pseudo-American Call Option Value Definition

A

The maximum of the value derived by the assumptions that the option will be held until expiration and the option will be exercised just before an ex-dividend date.

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7
Q

Hedge Ratio (Delta) Definition

A

The number of stocks required to hedge against the price risk of holding one option.

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8
Q

Option Elasticity Definition

A

The % increase in an option’s value given a 1% change in the value of the underlying asset.

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9
Q

Portfolio Insurance Definition

A

The practice of using options or dynamic hedging strategies to provide protection against investment losses while maintaining the upside potential.

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10
Q

Dynamic (Delta) Hedging Definition

A

Constant updating of hedge positions as market conditions change.

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11
Q

Gamma Definition

A

The curvature of an option-pricing function as a function of the value of the underlying asset.

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12
Q

Delta-Neutral Definition

A

The value of the portfolio is not affected by changes in the underlying asset.

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13
Q

Vega Definition

A

Response of option prices to changes in the standard deviation of the underlying asset.

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14
Q

How are options valued?

A

As the sum of their time value plus their intrinsic value.

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15
Q

What is the maximum an option holder can lose?

A

100% of the initial investment.

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16
Q

Lower exercise prices result in _______ call option prices.

A

Higher

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17
Q

Lower dividend payments result in _______ call option prices.

A

Higher

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18
Q

Lower stock prices result in _______ call option prices.

A

Lower

19
Q

Lower interest rates result in _______ call option prices.

A

Lower

20
Q

Lower volatility result in _______ call option prices.

A

Lower

21
Q

Less time to expiration results in _______ call option prices.

A

Lower

22
Q

Greater exercise prices result in _________ call option prices.

A

Lower

23
Q

Greater stock prices result in _________ call option prices.

A

Higher

24
Q

Greater interest rates result in _________ call option prices.

A

Higher

25
Q

Greater time to expiration results in _________ call option prices.

A

Higher

26
Q

Greater volatility results in _________ call option prices.

A

Higher

27
Q

Greater dividend payments result in _________ call option prices.

A

Lower

28
Q

What is the minimum price of a call option?

A

S - PV(X) - PV(d)
The stock price minus the present value of the exercise price and the present value of any dividends to be paid before expiration.

29
Q

When is there incentive to exercise a call option early?

A

When the call option pays dividends before the expiration date?

30
Q

Is there any benefit to exercising a call option on a non-dividend paying stock early?

A

No.

31
Q

As n -> infinity, does the binomial model get more or less accurate?

A

More accurate

32
Q

Is the Black-Scholes formula more or less limiting than the binomial model?

A

More limiting

33
Q

When can the Black-Scholes formula be easily adjusted for dividend payments?

A

When it is pricing European call options. It cannot be easily adjusted for American call options on stocks that pay dividends.

34
Q

Are American or European put options worth more, all else held equal?

A

American put options because there can be value to exercising early.

35
Q

Can American put prices be derived from the put-call parity relationship?

A

No because they can be exercised early.

36
Q

How can implied volatility be calculated?

A

Using the option-pricing model to find the stock volatility that makes an option’s value equal to its observed price.

37
Q

When are hedge ratios near 0?

A

For deeply out-of-the-money call options.

38
Q

When are hedge ratios near 1?

A

For deeply in-the-money call options.

39
Q

Can hedge ratios for call options be greater than 1?

A

No

40
Q

Can elasticities of call options be greater than 1?

A

Yes. The rate of return on a call responds more than one-for-one with stock price movement.

41
Q

How can portfolio insurance be obtained for an equity position?

A

By buying a protective put option on that equity position, or using a dynamic hedging strategy.

42
Q

Are delta-neutral portfolios independent of price changes in the underlying asset?

A

Yes

43
Q

Are delta-neutral portfolios independent of volatility changes in the underlying asset?

A

Yes

ECON435 (5 decks)

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