Chapter 17. Options on stock indices and currencies

Question 1

Stock index options

Answer 1

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.

Question 2

Currency options

Answer 2

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.

Question 3

European-style options

Answer 3

European-style options can only be exercised at expiration. They are the most common type of option traded on stock indices and currencies.

Question 4

Range forward contract

Answer 4

A variation on a standard forward contract used for hedging foreign exchange risk.

Question 5

Short forward contract

Answer 5

A contract where a company agrees to sell a certain amount of a currency at a specified price at a future date.

Question 6

European put option

Answer 6

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.

Question 7

European call option

Answer 7

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.

Question 8

European call option

Answer 8

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.

Question 9

Range forward contract payoff

Answer 9

The amount a company receives or pays in a range forward contract, depending on the exchange rate at the time of settlement.

Question 10

Long position

Answer 10

A position where a company agrees to buy a certain amount of a currency at a specified price at a future date.

Question 11

Exchange rate volatility

Answer 11

The amount of fluctuation in exchange rates over a given period of time.

Question 12

DerivaGem

Answer 12

A financial modeling software used to analyze and value derivatives.

Question 13

What is the simple rule for valuing European options on a stock paying a known dividend yield?

Answer 13

Reduce the current stock price from S0 to S0e^-qT and then value the option as though the stock pays no dividends.

Question 14

How does a dividend yield affect stock prices?

Answer 14

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.

Question 15

What happens to the stock price in the presence of dividends?

Answer 15

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.

Question 16

How does the probability distribution for the stock price at time T change in the presence of dividends?

Answer 16

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.

Question 17

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?

Answer 17

It enables us to value options on stock indices and currencies.

Question 18

How are index options settled?

Answer 18

Index options trading on exchanges are settled in cash.

Question 19

What does the holder of an index call option contract typically receive on exercise?

Answer 19

The holder of an index call option contract typically receives 100 times the amount by which the index exceeds the strike price on exercise.

Question 20

How can index options be used for portfolio insurance?

Answer 20

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.

Question 21

What are currency options typically used for by corporate treasurers?

Answer 21

Currency options can be used by corporate treasurers to hedge a foreign exchange exposure.

Question 22

What is the Black-Scholes-Merton formula extension used for?

Answer 22

The Black-Scholes-Merton formula extension can be used to value European options on stock indices and currencies.