Financial Options Flashcards
What is a financial derivative?
Any financial security whose payoff is derived from another underlying asset.
What are examples of financial derivatives?
Financial options, futures and swaps.
What is a financial option?
A financial option gives its holder the right to buy or sell an asset at a predetermined price at some future date.
True or false: the holder of a financial option is the long position.
True
Who is the option writer?
The first seller (short position) of an option contract in the primary market
What is call option?
A call option gives the holder (long position) the right to buy a security at a predetermined price at some future date.
What is a put option?
A put option gives the holder (long position) the right to sell a security at a predetermined price at some future date.
True or false: the buyer of a call option has the obligation to buy the asset.
False
True or false: the buyer of a call option has the right to buy the asset.
True
True or false: the seller of a call option has the obligation to sell the asset.
True
True or false: the seller of a call option has the obligation to buy the asset.
False
True or false: the seller of a put option has the obligation to sell the asset.
False
True or false: the seller of a put option has the obligation to buy the asset.
True
True or false: the buyer of a put option has the obligation to sell the asset.
False
True or false: the buyer of a put option has the right to sell the asset.
True
True or false: the buyer of a put option has the right to buy the asset.
False
What does it mean to exercise an option?
When a holder of an option chooses to buy or sell the underlying security at the agreed-upon price.
What is the strike price?
The price at which an option holder (long position) buys or sells the security when the option is exercised.
True or false: the strike price is the exercise price.
True
When can an american option be exercised?
At any time up to the expiration date (maturity).
When can an european option be exercised?
At the expiration date (maturity).
True or false: an european option can always be exercised.
False
True or false: an american option can always be exercised.
False
True or false: an american option can always be exercised up to maturity date.
True
What is the intrinsic value of an option?
Intrinsic value of an option is the payoff achieved if the option is exercised immediately.
What is the intrinsic value of a call option?
S - K
What is the intrinsic value of a put option?
K - S
What does it mean when an option is at-the-money?
Intrinsic value is 0.
What does it mean an option is in-the-money?
Positive intrinsic value
What does it mean an option is out-of-the-money?
Negative intrinsic value
When calculating a payoff, does it matter if the option can’t be exercised immediatly?
No, what matters is what would be the payoff if it was exercised immediatly.
True or false: if european options can only be exercised at the expiration date, we can’t calculate their payoffs before the expiration date.
False
What is hedging?
Hedging is reducing/eliminating portfolio’s risk.
Give an example of hedging.
Setting a minimum for what you receive from a portfolio even if the price of the stocks go below that minimum.
What is speculating?
To place a bet on the direction in which they believe the market is likely to move.
Where does the money between what the seller receives and what the buyer pays go?
To the house
When does a long position of a call option exercise?
When the stock’s price is higher than the exercise price (S > K)
When does a long position of a put option exercise?
When the exercise price is lower than the stock price (K > S)
What is the maximum loss on a purchased call option?
100%, when the option expires it’s worthless.
True or false: the maximum loss on a purchased call option is 100%.
True
Which options are more likely to expire worthless?
Out-of-the money options
When does an out-of-the-money option has a much higher return than an in-the-money call option?
When the stock’s price goes up enough.
True or false: call options have more extreme returns than the stock itself.
True
What is the maximum loss on a purchased put option?
100%, when it expires worthless.
True or false: the maximum loss on a purchased put option is 100%.
True
When do put options have higher returns?
States with low stock prices.
True or false: put options are generally not held as an investment, but rather as insurance to hedge other risks in a portfolio.
True.
What is a straddle?
A portfolio that is long a call option and a put option on the same stock with the same exercise date and strike price.
When do investors use a straddle strategy?
This strategy may be used if investors expect the stock to be very volatile and move up or down a large amount, but do not necessarily have a view on which directions the stock will move.
What is a strangle portfolio?
Long Call + Long Put on the same stock, with same T but with with K(Call) > K(Put).
What is a butterfly spread portfolio?
Long on 2 Call options with differing strike prices, and short two Call options with K = average strike prices of the first 2 Call options.
What is a protective put?
Long position on the stock plus a long position on a put over the same stock
What happens when we combine a long position in the stock and in a put held on the stock?
We eliminate the risk that the stock price decreases and we preserve the possibility to make money if the stock price increases.
What do we mean by relative valuation of an option?
We price a financial asset as a function of other assets. We use the Put-Call Parity.
What do we mean by absolute valuation methods?
We price a financial asset by itself. We use the Binomial Model and the Black-Scholes Model.
Why does computing the value of an option through the present value of all future cash flows doesn’t work?
Because the expected return and risk of an option change (nonlinearly) every time the underlying asset price moves.
What are the conditions to use Put-Call Parity?
1) Both options (Call and Put) need to be European style.
2) Both options (Call and Put) need to have the same underlying asset.
3) Both options (Call and Put) need to have the same strike price (K).
4) Both options (Call and Put) need to have the same expiration date.
True or false: we can use the Put-Call Parity to calculate the price of american options.
False
True or false: we can use the Put-Call Parity to calculate the price of european options.
True
True or false: when we use the Put-Call Parity, the options can have different underlying assets.
False
True or false: when we use the Put-Call Parity, the options can have different strike prices.
False
True or false: when we use the Put-Call Parity, the options can have different expiration dates.
False
True or false: when we use the Put-Call Parity, the options need to have the same expiration date.
True
True or false: when we use the Put-Call Parity, the options need to have the same strike price.
True
True or false: when we use the Put-Call Parity, the options need to have the same underlying asset.
True
In the Put-Call Parity, what does it mean if a value is positive?
We are selling the respective component.
In the Put-Call Parity, what does it mean if a value is negative?
We are buying the respective component.
What is equivalent to selling a call today?
Selling a put today, shorting the underlying asset and depositing the PV(K).
What is equivalent to buying a call today?
Buying a put today, buying the underlying asset and borrowing the PV(K)
What is the same as borrowing the PV(K)?
Shorting the PV(K) in a risk-free zero-coupon bonds.
What is the same as depositing the PV(K)?
Buying the PV(K) in risk-free zero-coupon bonds
True or false: dividends always matter when using the Put-Call Parity.
False
When do dividends matter in the Put-Call Parity?
When they’re paid before the expiration date.
True or false: we have to consider the same time for PV(K) and PV(DPS).
False
What maturity should you consider for the PV(K)?
Same as options (expiration date)
What is the assumption of the Binomial Model?
The binomial model has the assumption the underlying asset price evolves throughout time according to a binomial distribution (at each point in time you only have two options: up or down).
Which techniques can we use to solve the Binomial Model?
Replicating Portfolio and the Risk-neutral probabilities.
How do we use the technique of replicating portfolio?
We set up an option equivalent by combining the stock (underlying asset) and a risk-free bond with the same payoffs and therefore same value (Law of One Price).
How do we use the technique of risk-neutral probabilities?
We create risk-adjusted probabilities and apply present value formula with these artificial probabilities.
What is the difference between the Binomial Model and the Black-Scholes model?
While the Binomial Model assumes discrete changes in stock prices, the Black-Scholes assumes stock prices change continuously. The Black-Scholes Model is a continuous-time version of the Binomial Model: instead of assuming that the underlying asset follows a binomial distribution it assumes that it follows a standard normal distribution.
True or false: we can use the Black-Scholes Model to price european options.
True
True or false: we can use the Black-Scholes Model to price american options.
False
True or false: we can use the Binomial Model to price american options.
True
True or false: the Black-Scholes Model can be derived from the Binomial Model.
True
How can we derive the Black-Scholes Model from the Binomial Model?
The Black-Scholes Model can be derived from the Binomial Option Pricing Model by allowing the length of each period to shrink to zero and letting the number of periods grow infinitely large.
Which inputs do we need to use the Black-Scholes Model?
Current Stock Price, Strike Price, Exercise date, Risk-free rate and the Volatility of the stock.
How is the exercise date measured?
In volatility’s frequency.
True or false: the T in d1 and d2 are the same.
False
Why is the T different in d1 and d2?
Because the periods are always counted in the same frequency as the discount rate.
What happens to the call option’s price when the stock price increases?
Increases
What happens to the put option’s price when the stock price increases?
Decreases
True or false: when the stock price increases, the price of a call option decreases.
False
True or false: when the stock price increases, the price of a put option decreases.
True
True or false: when the stock price decreases, the price of a call option decreases.
True
True or false: when the stock price decreases, the price of a call option increases.
False
True or false: when the stock price decreases, the price of a put option decreases.
False
True or false: when the stock price decreases, the price of a put option increases.
True
What happens to the call option’s price when the exercise price increases?
Decreases
What happens to the put option’s price when the exercise price increases?
Increases
True or false: when the exercise price increases, the call option’s price decreases.
True
True or false: when the exercise price increases, the call option’s price increases.
False
True or false: when the exercise price increases, the put option’s price decreases.
False
True or false: when the exercise price increases, the call option’s price increases.
False
True or false: when the exercise price decreases, the call option’s price decreases.
False
True or false: when the exercise price decreases, the call option’s price increases.
True
True or false: when the exercise price decreases, the put option’s price increases.
False
What happens to the put option’s price when the maturity increases?
Increases
What happens to the call option’s price when the maturity increases?
Increases
Why do both put and call options’ prices increase when maturity increases?
Because we’re giving the underlying asset more time to change.
True or false: when the maturity increases both the call and put options’ prices increase.
True
What happens to the put option’s price when the volatility increases?
Increases
What happens to the call option’s price when the volatility increases?
Increases
True or false: when the volatility increases both the call and put options’ prices decrease.
False
Of the five inputs needed in the Black-Scholes formula, which isn’t observed directly?
Volatility
What is implied volatility?
The volatility of an asset’s returns that is consistent with the quoted price of an option on the asset.
How can we estimate the volatility?
Use historical data.
True or false: The short position in a Call option might have the obligation to buy the underlying asset (e.g., stock) at the strike price.
False
True or false: The intrinsic value of a Put option is given by the market price of the underlying asset (e.g., stock) minus the strike price
False
True or false: Consider that the current market price of the underlying asset (e.g., stock) is greater than the strike price of a given Put. That Put option is currently traded out-of-the-money.
True
True or false: The CAPM model assumes that markets should provide a premium for holding stocks that present higher levels of idiosyncratic risk.
False. The CAPM model states that only systematic risk determines the equilibrium return for any security or portfolio. The level of systematic risk is captured through the beta.
True or false: According to the CAPM model, two portfolios with the same beta have the same total risk.
False. According to the CAPM model two portfolios with the same beta have the same exposure to systematic risk. This does not imply that the idiosyncratic risk presented in each of the two portfolios is the same, and hence it does not imply that the total risk is the same.
True or false: . The short position in a Call option might have the obligation to sell the underlying asset (e.g., stock) at the strike price.
True
True or false: The intrinsic value of a Put option is given by the strike price minus the market price of the underlying asset (e.g., stock).
True
True or false: The price of an American Call is always higher or equal than the value of an identical European Call (the remaining conditions are the same).
True
What is a bullish vertical spread?
A bull vertical spread is an options strategy used when the investor expects a moderate rise in the price of the underlying asset. Bull vertical spreads involve simultaneously buying and selling options with the same expiration date on the same asset but at different strike prices.
When does an investor create a bull vertical spread?
When the investor expects a moderate rise in the price of the underlying asset.
What is a bearish vertical spread?
A bearish vertical call spread is created when the investor sells a call option and buys a higher strike call option with the same expiration date. Bearish vertical call spreads are entered for a credit and are also called call credit spreads. The strategy profits from a decrease in the underlying asset’s price.
