financial option valuation techniques

Question 1

1997 Nobel Prize (Black-Scholes Option Pricing Model)

Answer 1

robert merton
mryon scholes
fischer black

Question 2

COMMON TECHNIQUES - derived from Black and Scholes’ insights

Answer 2

black scholes option pricing model
binomial option pricing model
risk neutral probabilities
risk and return of an option
corporate governance of option pricing

Question 3

gives holder the right (but not the obligation) to purchase an asset at some future date.

Answer 3

call option

Question 4

gives the holder the right to sell an asset at some future date.

Answer 4

put option

Question 5

the price at which the holder agrees to buy or sell the share of stock when the option is exercised.

Answer 5

strike price or exercise price

Question 6

the last date on which the holder has the right to exercise the option.

Answer 6

expiration date

Question 7

can be exercised on any date up to, and including the exercise date.

Answer 7

american option

Question 8

can be exercised only on the expiration date.

Answer 8

european option

Question 9

It can be derived from the Binomial Option Pricing Model by making the length of each period, and the movement of the stock price per period, shrink to zero and letting the number of periods grow infinitely large.

Answer 9

black scholes option pricing model

Question 10

5 Input Parameters to price the call

Answer 10

a.Stock Price
b.Strike Price
c.Exercise Date
d.Risk-free Rate
e.Volatility of the Stock

Question 11

An option can be valued using a portfolio that replicates the payoffs of the option in different states.

Answer 11

Binomial Option Pricing Model

Question 12

It assumes two possible states for the next time period, given today’s state.

Answer 12

binomial option pricing model

Question 13

The value of an option is the value of the portfolio that replicates its payoffs. The replicating portfolio will hold the underlying asset and risk-free debt, and will need to be rebalanced over time.

Answer 13

binomial option pricing model

Question 14

a portfolio of other securities that has exactly the same value in one period as the option.

Answer 14

two state single period model

Question 15

there are more than two possible outcomes for the stock price in the real world.

Answer 15

Multiperiod Model

Question 16

also known as state-contingent prices, state prices, or martingale prices.

Answer 16

risk neutral probabilities

Question 17

probabilities under which the expected return of all securities equals the risk-free rate. These probabilities can be used to price any other asset for which the payoffs in each state are known.

Answer 17

risk neutral probabilities

Question 18

In a binomial tree, the risk-neutral probability p that the stock price will increase is given by

Answer 18

risk neutral probabilities

Question 19

any security whose payoff depends solely on the prices of other marketed assets.

Answer 19

derivative security

Question 20

the basis for a common technique for pricing derivative securities called Monte Carlo simulation.

Answer 20

risk neutral pricing method

Question 20

The beta of an option can also be calculated by computing the beta of its replicating portfolio.

Answer 20

risk and return of an option

Question 21

For stocks with positive betas, calls will have _____ betas than the underlying stock, while puts will have ______ betas.

Answer 21

larger;negative

Question 21

In the randomization, the _______ are used, and so the average payoff can be discounted at the risk-free rate to estimate the derivative security’s value.

Answer 21

risk-neutral probabilities

Question 21

For stocks with positive betas, calls will have larger betas than the underlying stock, while puts will have negative betas. The magnitude of the option beta is higher for options that are further out of the money.

Answer 21

risk and return of an option

Question 22

As the stock price changes, the beta of an option will change, with its magnitude falling as the option goes in-the-money.

Answer 22

risk and return of an option

Question 23

Expected returns and beta are______ related.

Answer 23

risk and return of an option; linearly

Question 24

unlevering the beta of equity and calculating the beta of risky debt

Answer 24

Corporate Applications of Option Pricing

Question 25

deriving the approximation formula to value debt overhang

Answer 25

Corporate Applications of Option Pricing

Question 26

USES OF OPTION PRICING METHODS

Answer 26

assess potential investment distortions that might arise due to debt overhang, or the incentive for asset substitution and risk-taking.
evaluate state-contingent costs, such as financial distress costs.
enhance the value of the firm.