Chapter 12 Characteristics Of Derivative Securities Flashcards
Derivative
A derivative is a security or contract which promises to make a payment at a specified time in the future, the amount of which depends upon the behavior of some underlying security up to and including the time of the payment.
List six types of underlying assets.
Shares Bonds Index Interest Rate Currency Commodity
Option
An option give an investor the right, but not the obligation, to buy or sell a specified asset on a specified future date.
Call Option
A call option gives the right, but not the obligation, to buy a specified asset on a set date in the future for a specified price.
Put Option
A put option gives the right but not the obligation, to sell a specified asset on a set date in the future for a specified price
European Option
A European option is an option that can only be exercised at expiry.
American Option
An American option is one that can be exercised on any date before its expiry.
Explain the difference between the long and the short position.
A long position on a contract is when the contract has been purchased, while a short position is when the contract is sold.
Arbitrage Opportunity
Situation where we can make a riskless profit
a) We start at time 0 with a portfolio that has a net value of zero (implying we are long in some assets and short in others). Aka a zero cost portfolio.
b) At some future time T:
1. The probability of a loss is 0.
2. The probability that we make a strictly positive profit is greater than 0.
Law of one price
If we assume that there are no arbitrage opportunities in the market, then it follows that any two securities or combination of securities that give exactly the same payments must have the same price.
Explain how the share price will effect the price of European call and put options.
Eu Call Option
If St increases, then the intrinsic value of the option (max{St-K, 0}) will increase. Therefore the option price(ct) will increase.
Eu Put Option
If St increases, then the intrinsic value of the option (max{K-St, 0}) will decrease. Therefore the option price (pt) will decrease.
Explain how the strike price effects both European call and put options.
Eu Call Option
If K increases, then the intrinsic value of the option (max{St-K, 0}) decreases. Therefore the option price (ct) will decrease.
Eu Put Option
If K increases, then the intrinsic value of the option (max {K-St, 0}) will increase. Therefore the option price (pt) will increase.
Explain how the time to maturity effects both European call and put options.
Eu Call and Put Option
If T-t increases, then we increase the chance of the share price moving in favour of the holder of the option before expiry. This increases the value of both options. Therefore both ct and pt will increase.
Explain how volatility effects the price of both European call and put options.
If volatility increases, we increase the chance of the share price moving in favour of the holder of the option before expiry. Therefore the value of both options increases. Therefore both ct and pt will increase
Recall downside risk is limited.
Explain how the risk free interest rate effects the price of both European call and put options.
Eu Call Option
If r increases, we want to delay purchase of the share to earn more interest on cash money. Therefore the value of the choice itself increases. Therefore the option price (ct) increase.
Eu Put Option
If r increases, we want to sell actual share now to earn cash money to invest in the risk free asset. So the option becomes less valuable when the looking in terms of delaying sale of the share. Therefore the option price (pt) will decrease
