2.6 Derivatives and Risk-Neutral Valuation Flashcards
Slope of the term structure of forward prices is governed by the underlying security’s financing cost (r) and dividend yield (y)
Describe the slope:
1. r=q:
2. r>q:
3. r<q:
- r=q: flat
- r>q: upward
- r<q: downward
Define cost of carry
Direct financial difference between holding a position in the cash market and holding a position in the forward market, .e.g physical wheat’s storage cost
What are the four factors that differentiate forward pricing on financial assets vs physical assets?
- Forecast of supply and demand changes
- Storage cost differentials
- Convenience yield differentials
- Difficulties with short-selling
What’s the difference between Bull and Bear Spread?
Bull = short call + long call with lower strike price
Bear = short put + long put with higher strike
What’s the difference between Straddle and Strangle?
Straddle: call and put with same sign
Strangle: call and put with the same sign, but different strike price
What is Put Call parity?
Call + Bond - Put = Asset
OR
Stock + Put = Bond + Call
What does option price depend on? Five variables
1) the underlying asset price
2) the strike price
3) the underlying asset’s return volatility
4) the option’s time to expiration
5) the risk-free rate.
What are the five popular Greeks that demonstrate option sensitivities?
- Delta: asset value
- Vega: asset vols
- Theta: time to maturity
- Rho: risk free rate
- Gamma
Uses of option sensitivities in Risk Management
- Hedging
- Manage risk to each derivative
- Identify effect of finite changes on value of position, e.g. convexity of bond
Define the following Greeks:
1. Omnicron
2. Gamma
3. Elasticity
4. Lambda
- Omicron presents an option’s sensitivity to changes in credit risk/spread.
- Gamma is an option value’s second partial derivative with respect to the option’s underlying asset.
- Elasticity represents the percentage change in an asset’s value with respect to a percentage change in another value.
- Lambda represents an option’s price elasticity with respect to its underlying asset price
According to put-call parity, which of the following is equivalent to a risk-free, zero-coupon bond?
1. Risk reversal
2. Long collar
3. Covered call
4. Protective put
Bond = Stock + Put - Call
Long collar = + Put - Call
- Covered call = Long asset + Short call (= Asset – Call)
- Risk reversal = Long call + Short put (= Call – Put)
- Protective put = Long asset + Long put (= Asset + Put)
Note: A collar position is equivalent to a protective put and a covered call.