21: Option Valuation Flashcards
Intrinsic Value Definition
The present value of a firm’s expected future net cash flows discounted by the required rate of return.
Time Value Definition
The part of the value of an option that is due to positive time to expiration.
Binomial Model Definition
An option valuation model predicted using the assumption that the stock price can move to only two values over a short time period.
Black-Scholes Pricing Formula
An equation to value a call option.
Implied Volatility Definition
The standard deviation of stock returns that is consistent with an option’s market value.
Pseudo-American Call Option Value Definition
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.
Hedge Ratio (Delta) Definition
The number of stocks required to hedge against the price risk of holding one option.
Option Elasticity Definition
The % increase in an option’s value given a 1% change in the value of the underlying asset.
Portfolio Insurance Definition
The practice of using options or dynamic hedging strategies to provide protection against investment losses while maintaining the upside potential.
Dynamic (Delta) Hedging Definition
Constant updating of hedge positions as market conditions change.
Gamma Definition
The curvature of an option-pricing function as a function of the value of the underlying asset.
Delta-Neutral Definition
The value of the portfolio is not affected by changes in the underlying asset.
Vega Definition
Response of option prices to changes in the standard deviation of the underlying asset.
How are options valued?
As the sum of their time value plus their intrinsic value.
What is the maximum an option holder can lose?
100% of the initial investment.
Lower exercise prices result in _______ call option prices.
Higher
Lower dividend payments result in _______ call option prices.
Higher
Lower stock prices result in _______ call option prices.
Lower
Lower interest rates result in _______ call option prices.
Lower
Lower volatility result in _______ call option prices.
Lower
Less time to expiration results in _______ call option prices.
Lower
Greater exercise prices result in _________ call option prices.
Lower
Greater stock prices result in _________ call option prices.
Higher
Greater interest rates result in _________ call option prices.
Higher
Greater time to expiration results in _________ call option prices.
Higher
Greater volatility results in _________ call option prices.
Higher
Greater dividend payments result in _________ call option prices.
Lower
What is the minimum price of a call option?
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.
When is there incentive to exercise a call option early?
When the call option pays dividends before the expiration date?
Is there any benefit to exercising a call option on a non-dividend paying stock early?
No.
As n -> infinity, does the binomial model get more or less accurate?
More accurate
Is the Black-Scholes formula more or less limiting than the binomial model?
More limiting
When can the Black-Scholes formula be easily adjusted for dividend payments?
When it is pricing European call options. It cannot be easily adjusted for American call options on stocks that pay dividends.
Are American or European put options worth more, all else held equal?
American put options because there can be value to exercising early.
Can American put prices be derived from the put-call parity relationship?
No because they can be exercised early.
How can implied volatility be calculated?
Using the option-pricing model to find the stock volatility that makes an option’s value equal to its observed price.
When are hedge ratios near 0?
For deeply out-of-the-money call options.
When are hedge ratios near 1?
For deeply in-the-money call options.
Can hedge ratios for call options be greater than 1?
No
Can elasticities of call options be greater than 1?
Yes. The rate of return on a call responds more than one-for-one with stock price movement.
How can portfolio insurance be obtained for an equity position?
By buying a protective put option on that equity position, or using a dynamic hedging strategy.
Are delta-neutral portfolios independent of price changes in the underlying asset?
Yes
Are delta-neutral portfolios independent of volatility changes in the underlying asset?
Yes
