Chapter 08-09 Derivatives

Question 1

Bear spread

Answer 1

An option strategy that becomes more valuable when the price of the underlying asset declines, so requires buying one option and writing another with a lower exercise price. A put bear spread involves buying a put with a higher exercise price and selling a put with a lower exercise price. A bear spread can also be executed with calls.

Question 2

Bull spread

Answer 2

An option strategy that becomes more valuable when the price of the underlying asset rises, so requires buying one option and writing another with a higher exercise price. A call bull spread involves buying a call with a lower exercise price and selling a call with a higher exercise price. A bull spread can also be executed with puts.

Question 3

Calendar spread

Answer 3

A strategy in which one sells an option and buys the same type of option but with different expiration dates, on the same underlying asset and with the same strike. When the investor buys the more distant (near-term) call and sells the near-term (more distant) call, it is a long (short) calendar spread.

Question 4

Cash-secured put

Answer 4

An option strategy involving the writing of a put option and simultaneously depositing an amount of money equal to the exercise price into a designated account (this strategy is also called a fiduciary put).

Question 5

Collar

Answer 5

An option position in which the investor is long shares of stock and then buys a put with an exercise price below the current stock price and writes a call with an exercise price above the current stock price. Collars allow a shareholder to acquire downside protection through a protective put but reduce the cash outlay by writing a covered call.

Question 6

Covered call

Answer 6

An option strategy in which a long position in an asset is combined with a short position in a call on that asset.

Question 7

Cross-currency basis swap

Answer 7

An interest rate swap involving the periodic exchange of floating payments in one currency for another based upon respective market reference rates with an initial and final exchange of notional principal.

Question 8

Delta

Answer 8

The change in an option’s price in response to a change in price of the underlying, all else equal.

Question 9

Effective federal funds (FFE) rate

Answer 9

The fed funds rate actually transacted between depository institutions, not the Fed’s target federal funds rate.

Question 10

Gamma

Answer 10

The change in an option’s delta for a change in price of the underlying, all else equal.

Question 11

Implied volatility

Answer 11

The outlook for the future volatility of the underlying asset’s price. It is the value (i.e., standard deviation of underlying’s returns) that equates the model (e.g., Black, Scholes, Merton model) price of an option to its market price.

Question 12

Implied volatility surface

Answer 12

A three-dimensional plot, for put and call options on the same underlying asset, of days to expiration (x-axis), option strike prices (y-axis), and implied volatilities (z-axis). It simultaneously shows the volatility skew (or smile) and the term structure of implied volatility.

Question 13

Position delta

Answer 13

The overall or portfolio delta. For example, the position delta of a covered call, consisting of long 100 shares and short one at-the-money call, is +50 (= +100 for the shares and -50for the short ATM call).

Question 14

Protective put

Answer 14

An option strategy in which a long position in an asset is combined with a long position in a put on that asset.

Question 15

Realized volatility

Answer 15

Historical volatility, the square root of the realized variance of returns, which is a measure of the range of past price outcomes for the underlying asset.

Question 16

Risk reversal

Answer 16

A strategy used to profit from the existence of an implied volatility skew and from changes in its shape over time. A combination of long (short) calls and short (long) puts on the same underlying with the same expiration is a long (short) risk reversal.

Question 17

Straddle

Answer 17

An option combination in which one buys both puts and calls, with the same exercise price and same expiration date, on the same underlying asset. In contrast to this long straddle, if someone writes both options, it is a short straddle.

Question 18

Strangle

Answer 18

A variation on a straddle in which the put and call have different exercise prices; if the put and call are held long, it is a long strangle; if they are held short, it is a short strangle.

Question 19

Synthetic long forward position

Answer 19

The combination of a long call and a short put with identical strike price and expiration, traded at the same time on the same underlying.

Question 20

Synthetic short forward position

Answer 20

The combination of a short call and a long put at the same strike price and maturity (traded at the same time on the same underlying).

Question 21

Term structure of volatility

Answer 21

The plot of implied volatility (y-axis) against option maturity (x-axis) for options with the same strike price on the same underlying. Typically, implied volatility is not constant across different maturities - rather, it is often in contango, meaning that the implied volatilities for longer-term options are higher than for near-term ones.

Question 22

Theta

Answer 22

The daily change in an option’s price, all else equal. Theta measures the sensitivity of the option’s price to the passage of time, known as time decay.

Question 23

Variance notional

Answer 23

The notional amount of a variance swap; it equals vega notional divided by two times the volatility strike price.

Question 24

Vega

Answer 24

The change in an option’s price for a change in volatility of the underlying, all else equal.

Question 25

Vega notional

Answer 25

The trade size for a variance swap, which represents the average profit and loss of the variance swap for a 1% change in volatility from the strike.

Question 26

Volatility skew

Answer 26

The skewed plot (of implied volatility (y-axis) against strike price (x-axis) for options on the same underlying with the same expiration) that occurs when the implied volatility increases for OTM puts and decreases for OTM calls, as the strike price moves away from the current price.

Question 27

Volatility smile

Answer 27

The U-shaped plot (of implied volatility (y-axis) against strike price (x-axis) for options on the same underlying with the same expiration) that occurs when the implied volatilities priced into both OTM puts and calls trade at a premium to implied volatilities of ATM options.