Chapter 17. Options on stock indices and currencies Flashcards
Stock index options
Stock index options are options where the underlying asset is a stock index, such as the S&P 500 index. These options are settled in cash and are widely used for both hedging and speculation.
Currency options
Currency options are options where the underlying asset is a foreign currency. These options can be used for hedging or speculation, and are settled in cash in most cases.
European-style options
European-style options can only be exercised at expiration. They are the most common type of option traded on stock indices and currencies.
Range forward contract
A variation on a standard forward contract used for hedging foreign exchange risk.
Short forward contract
A contract where a company agrees to sell a certain amount of a currency at a specified price at a future date.
European put option
A financial contract that gives the holder the right, but not the obligation, to sell a currency at a specified price at a future date.
European call option
A financial contract that gives the holder the right, but not the obligation, to buy a currency at a specified price at a future date.
European call option
A financial contract that gives the holder the right, but not the obligation, to buy a currency at a specified price at a future date.
Range forward contract payoff
The amount a company receives or pays in a range forward contract, depending on the exchange rate at the time of settlement.
Long position
A position where a company agrees to buy a certain amount of a currency at a specified price at a future date.
Exchange rate volatility
The amount of fluctuation in exchange rates over a given period of time.
DerivaGem
A financial modeling software used to analyze and value derivatives.
What is the simple rule for valuing European options on a stock paying a known dividend yield?
Reduce the current stock price from S0 to S0e^-qT and then value the option as though the stock pays no dividends.
How does a dividend yield affect stock prices?
Dividends cause stock prices to reduce on the ex-dividend date by the amount of the dividend payment. The payment of a dividend yield at rate q therefore causes the growth rate in the stock price to be less than it would otherwise be by an amount q.
What happens to the stock price in the presence of dividends?
With a dividend yield of q, the stock price grows from S0 today to ST at time T. Alternatively, in the absence of dividends it would grow from S0e^-qT today to ST at time T.
How does the probability distribution for the stock price at time T change in the presence of dividends?
The same probability distribution for the stock price at time T is obtained in both cases: 1) the stock starts at price S0 and provides a dividend yield at rate q, and 2) the stock starts at price S0e^-qT and pays no dividends.
What does the extension of valuation results for European options on a non-dividend-paying stock to European options on a stock paying a known dividend yield enable us to do?
It enables us to value options on stock indices and currencies.
How are index options settled?
Index options trading on exchanges are settled in cash.
What does the holder of an index call option contract typically receive on exercise?
The holder of an index call option contract typically receives 100 times the amount by which the index exceeds the strike price on exercise.
How can index options be used for portfolio insurance?
If the portfolio mirrors the index, one put option contract should be purchased for each 100S0 dollars in the portfolio, where S0 is the value of the index. Otherwise, b put option contracts should be purchased for each 100S0 dollars in the portfolio, where b is the beta of the portfolio from the capital asset pricing model.
What are currency options typically used for by corporate treasurers?
Currency options can be used by corporate treasurers to hedge a foreign exchange exposure.
What is the Black-Scholes-Merton formula extension used for?
The Black-Scholes-Merton formula extension can be used to value European options on stock indices and currencies.
