chapter 12: options

Question 1

call option price characteristics

Answer 1

· They approach their intrinsic value for deep in and deep out of the money calls.

· They increase with the price of the underlying asset

· They decrease with a higher strike price

· They increase if the underlying asset is riskier

· They increase as the time to expiration increases

· They decrease as the dividend payments of the underlying asset increase

· They increase as interest rates increase

Question 2

call option

Answer 2

the right, but not the obligation, to buy an underlying asset at a fixed price for a specified time

Question 3

exercise price or strike price

Answer 3

the price at which an investor can buy the underlying asset

Question 4

exercise

Answer 4

to implement the rights of options by buying (in the case of call options) or selling (in the case of put options)

Question 5

expiration date

Answer 5

the last date on which options can be converted or exercised

Question 6

in the money

Answer 6

the option would generate a positive payoff if exercised today

Question 7

out of the money

Answer 7

the option would generate a negative payoff if exercised today

Question 8

how can we see the payoffs of a call option on a graph

Answer 8

it is a 45 degree line with a slope of $1 payoff to $1 price

it is a horizontal line right before it slopes up until it reaches the strike price (after that, it goes up)

Question 9

option writer

Answer 9

the person who sells an option

Question 10

short position

Answer 10

the position taken by the option writer

Question 11

what is the payoff of a short position?

Answer 11

the mirror of the payoff of someone having a call position

Question 12

intrinsic value (IV)

Answer 12

the value of an option at expiration

it is positive when the option is in the money and zero when it is at or out of the money

Question 13

time value (TV)

Answer 13

the difference between the option premium and the intrinsic value

Question 14

option premium

Answer 14

the market value of the option

the sum of an option’s IV and TV

Question 15

deep

Answer 15

options that are so far in (out of) the money that they are almost certain (not) to be exercised

Question 16

A put option

Answer 16

the opposite of a call option

gives the owner the right, but not the obligation, to sell an underlying asset at a fixed price for a specified time

we start with the opposite of a long position in the underlying asset, which is a short position

Question 17

describe graphically the short position

Answer 17

it is a 45-degree line going through the forward price of $50

this is the mirror image of the long position (from left to right)

Question 18

the payoff on the put option

Answer 18

If the asset price increases, the investor does not exercise the put option

–> there is no reason to sell the asset for $50 when the investor can sell it in the open market for, say, $55

if the asset price drops to $45, the investor exercises the put

pay off when the asset price drops below the strike price, and they are worthless when the asset price is above the strike price

Question 19

the payoff for the put writer

Answer 19

a short position in the put

when it goes above the strike price, it is worthless for him too

The put writer’s payoff is the opposite of the put holder’s, because they have to pay $50 for an asset that can be sold for only $45, thereby incurring a $5 loss

it is the mirror image of the put holder’s payoff

Question 20

intrusive value formula for a call option

Answer 20

MAX (S - X, 0)

Question 21

intrusive value formula for a put option

Answer 21

MAX (X, 0 - S)

Question 22

what happens to the market price of call options when they are deep in and deep out of the money calls?

Answer 22

They approach their intrinsic value

Question 23

what happens to the market price of call options when the price of the underlying asset increases?

Answer 23

it increases as well

Question 24

what happens to the market price of call options the higher the strike price?

Answer 24

the more the call option price decreases

Question 25

what happens to the market price of call options when the underlying asset is riskier?

Answer 25

they increase

Question 26

what happens to the market price of call options when the time to expiration increases?

Answer 26

They increase

Question 27

what happens to the market price of call options when the dividend payments of the underlying asset increase?

Answer 27

They decrease

Question 28

what happens to the market price of call options when the interest rates increase

Answer 28

They increase

Question 29

what happens to the market price of call options when the interest rates increase

Answer 29

They increase

Question 30

what happens to the market price of put options when they are deep in and deep out of the money calls?

Answer 30

They approach their intrinsic value

Question 31

what happens to the market price of put options when the price of the underlying asset increases?

Answer 31

decreases the price

Question 32

what happens to the market price of put options the higher the strike price?

Answer 32

the price increases

Question 33

what happens to the market price of put options when the underlying asset is riskier?

Answer 33

increase in price as does for the call option

Question 34

what happens to the market price of put options when the time to expiration increases?

Answer 34

increase in price as does for the call option

Question 35

what happens to the market price of put options when the dividend payments of the underlying asset increase?

Answer 35

they increase

Question 36

what happens to the market price of put options when the interest rates increase

Answer 36

they decrease

Question 37

the major difference between puts and calls when it comes to whether or not an investor can exercise the option before the expiration date

when is this distinction important?

Answer 37

if they are European options or American options

the distinction is important for put options

Question 38

European options

Answer 38

options that can be exercised only at maturity

Question 39

options that can be exercised at any time up to and including the expiration date

Answer 39

American options