Definitions

Question 1

What is value?

Answer 1

Market or fair value of a contract - a price everyone agrees
on. The value of a contract is the amount another investor
would pay in exchange for the contract.

Question 2

Simple interest rate?

Answer 2

For the interest rate r the value V (T) at time T of holding P units of currency starting at time t = 0:
V (T) = (1 + rT)P
where T is expressed in years.

Question 3

Compound interest rate?

Answer 3

V (T) =(1 +(r/m))^mT . P

where m is the number interest payments made per annum

Question 4

Continuous compounding?

Answer 4

For a constant interest rate r the time value of money under
continuous compounding is given by:
V (T) = e^(rT) . P

Question 5

Return?

Answer 5

return = change in value over a period of time/

initial investment

Question 6

Modelling Return?

Answer 6

(dS/S) = µdt + σdW
µdt is a measure of the deterministic expected rate of growth of the stock price.
σdW describes the stochastic change in the stock price

Question 7

Ito’s Lemma?

Answer 7

df = [(∂f/∂t) + µS(∂f/∂S) +(1/2)σ^2 . S^2 . (∂^2 f/∂S^2))dt + σS(∂f/∂S)dW

Question 8

What is the geometric Brownian motion?

Answer 8

dS = µSdt + σSdW

Question 9

What is a derivative?

Answer 9

A financial instrument whose value depends
on the values of other underlying variables, A stock option, for example, is a derivative whose
value is dependent on a stock price.

Question 10

What is a European call option?

Answer 10

Gives the holder the right (not obligation)

to buy underlying asset at a prescribed time T for a specified (strike) price E.

Question 11

What is a European put option?

Answer 11

Gives its holder the right (not obligation)

to sell underlying asset at a prescribed time T for a specified (strike) price E.

Question 12

Payoff Diagram?

Answer 12

A graph of the value of the option position at

expiration t = T as a function of the underlying stock price S.

Question 13

What is Short selling?

Answer 13

The practice of selling assets that have been

borrowed from a broker with the intention of buying the same assets back at a later date to return to the broker.

Question 14

What is a Portfolio?

Answer 14

A combination of assets, options and bonds?

Question 15

What is Straddle?

Answer 15

The purchase of a call and a put on the same
underlying security with the same maturity time T and strike
price E. The value of portfolio is Π = C + P