Chapter 20/21-Options contracts

Question 1

What is a call?

Answer 1

An option to BUY an asset at a fixed price in specific future time

Question 2

What is a put?

Answer 2

An option to SELL an asset at a fixed price in specific future time

Question 3

What is a European option?

Answer 3

An option which can only be exercised at its expiration date

Question 4

What is an American option?

Answer 4

An option which can be exercised at any point before or on its expiration date

Question 5

When is a call in the money?

Answer 5

When the assets price is greater than it’s exercise/strike price

Question 6

When is a put ITM?

Answer 6

When the asset price is less than its strike/exercise price

Question 7

What is the put-call parity theorem?

Answer 7

• related the prices of put and call options.
• if the relationship is violated, arbitrage opportunities will result

Question 8

What two methods do we use to price option?

Answer 8

1. Binomial tree method
2. Black-Scholes valuation

Question 9

How can we form a risk less portfolio?

Answer 9

Form a portfolio consisting of the stocks and the option
- instantaneously risk less
- instantaneously earns the risk-feee rate

Question 10

What is delta?

Answer 10

• the rate of change of the option price with respect to the underlying stock value
• also the number of units of stock we should hold for each option shorted in order to create a risk less portfolio

Question 11

What is the construction of a risk less portfolio sometimes referred to as?

Answer 11

Delta hedging

Question 12

What is the aim of hedging?

Answer 12

• to create a delta neutral portfolio
• I.e zero-sum game