AF_L2 Flashcards
1
Q
What is an option?
A
- A contract giving the right, not obligation
- Call: right to buy
- Put: right to sell
2
Q
Risk-neutral probability
A
- Formula: p = ( (1 + r) − d ) / ( u − d )
- Eliminates risk preferences
- Used in option pricing
3
Q
Replicating portfolio
A
- Combine stock + loan to mimic option payoffs
- Delta measures shares to buy or sell
- Matches payoff of the actual option
4
Q
Delta (Δ)
A
- Rate of change of option value w.r.t. underlying price
- Δ = (Cu − Cd) / (Su − Sd)
5
Q
One-step binomial model
A
- Stock can move up (u) or down (d)
- Value option via replicating or risk-neutral methods
- Simple discrete approach
6
Q
Black–Scholes formula
A
- C = S·N(d₁) − PV(EX)·N(d₂)
- d1 and d2 depend on σ, r, t
- Continuous-time limit of binomial model
7
Q
Early exercise considerations
A
- American call on non-dividend stock rarely early-exercised
- Dividends can make early exercise beneficial
- Puts often exercised early if underlying price is very low
8
Q
Real options
A
- Flexibility in projects (expand, abandon, delay)
- Similar pricing logic to financial options
- Value arises from uncertainty + capacity to adapt
9
Q
Option to expand
A
- Invest now → future right to scale up
- More valuable with higher uncertainty
- Often seen in R&D or new markets
10
Q
Option to abandon
A
- Like a put on the project
- Exercise if future prospects are unfavourable
- Limits downside risk
11
Q
Timing option
A
- Right to delay an investment
- Useful if payoffs are uncertain
- Balances waiting for information vs. immediate returns
12
Q
Flexible production
A
- Switch inputs or outputs as prices change
- Resembles a portfolio of calls and puts
- Increases resilience to volatility
13
Q
Key takeaway
A
- Option pricing tools apply to real projects
- Identify underlying asset, strike, maturity
- Use risk-neutral approach or replicating portfolio
