Derivatives, Derivative Markets, Option Contracts and Option Valuation

Question 1

Define a derivative

Answer 1

financial instruments whose value depends on the values of other, more basic underlying assets

Question 2

What is an option?

Answer 2

An agreement that gives the owner the right to buy or sell a specific financial asset at a specific price for a set period of time

Question 3

What is the difference between call and put options?

Answer 3

Call gives right to buy, put gives the right to sell

Question 4

Give the two exercise styles

Answer 4

European - right to exercise only on expiration date

American - right to exercise on or before expiration date

Question 5

When would you exercise a call option?

Answer 5

When share price is STRICTLY ABOVE strike price

Question 6

What is the payoff when exercising a call option

Answer 6

Share price - strike price

Question 7

When would you exercise a put option?

Answer 7

If share price is STRICTLY LESS than strike price

Question 8

What is the payoff when exercising a put option?

Answer 8

Strike price - share price

Question 9

Describe the moneyness of a call opton

Answer 9

If K < S0, call is in the money

If K > S0, call is out of the money

Question 10

Describe the moneyness of a put option

Answer 10

If K < S0, put is out of the money

If K > S0, put is in the money

Question 11

Learn methods to price puts and calls, and how to price it using a binomial tree

Answer 11

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Question 12

What are factors affecting price/value of an option?

Answer 12

1. current stock price
2. strike price
3. time to expiration
4. risk free rate
5. variance of stock prices

Question 13

How do you discount using a risk free rate?

Answer 13

e^(-rf * t)

t is period in years

Question 14

Learn risk less hedge method

Answer 14

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Question 15

Learn risk neutral method

Answer 15

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Question 16

How do you estimate the binomial stock price process?

Answer 16

u = e^(σ*Δt)
d = e^-(σ*Δt)

Question 17

Give the put-call parity with continuous compounding

Answer 17

S + P = Ke^-(rf*t) + C

Question 18

Give the price of a call using the Black-Scholes pricing model

Answer 18

C = N(x1)S - Ke^-(rft) * N(x2)

Question 19

What are x1 and x2 in the Black-Scholes pricing model?

Answer 19

x1 = 1/σ*sqrt(t) * [ ln(S/K) + (rf + σ^2/2) * t ]

x2 = x1 - σ*sqrt(t)