2.6 Derivatives and Risk-Neutral Valuation Flashcards

1
Q

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:

A
  1. r=q: flat
  2. r>q: upward
  3. r<q: downward
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2
Q

Define cost of carry

A

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

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3
Q

What are the four factors that differentiate forward pricing on financial assets vs physical assets?

A
  1. Forecast of supply and demand changes
  2. Storage cost differentials
  3. Convenience yield differentials
  4. Difficulties with short-selling
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4
Q

What’s the difference between Bull and Bear Spread?

A

Bull = short call + long call with lower strike price

Bear = short put + long put with higher strike

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5
Q

What’s the difference between Straddle and Strangle?

A

Straddle: call and put with same sign

Strangle: call and put with the same sign, but different strike price

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6
Q

What is Put Call parity?

A

Call + Bond - Put = Asset
OR
Stock + Put = Bond + Call

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7
Q

What does option price depend on? Five variables

A

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.

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8
Q

What are the five popular Greeks that demonstrate option sensitivities?

A
  1. Delta: asset value
  2. Vega: asset vols
  3. Theta: time to maturity
  4. Rho: risk free rate
  5. Gamma
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9
Q

Uses of option sensitivities in Risk Management

A
  1. Hedging
  2. Manage risk to each derivative
  3. Identify effect of finite changes on value of position, e.g. convexity of bond
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10
Q

Define the following Greeks:
1. Omnicron
2. Gamma
3. Elasticity
4. Lambda

A
  1. Omicron presents an option’s sensitivity to changes in credit risk/spread.
  2. Gamma is an option value’s second partial derivative with respect to the option’s underlying asset.
  3. Elasticity represents the percentage change in an asset’s value with respect to a percentage change in another value.
  4. Lambda represents an option’s price elasticity with respect to its underlying asset price
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11
Q

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

A

Bond = Stock + Put - Call

Long collar = + Put - Call

  1. Covered call = Long asset + Short call (= Asset – Call)
  2. Risk reversal = Long call + Short put (= Call – Put)
  3. Protective put = Long asset + Long put (= Asset + Put)

Note: A collar position is equivalent to a protective put and a covered call.

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