Group 6

Question 1

Common Techniques derived from Black and Scholes’ insights

Answer 1

Black-Scholes Option Pricing Model
Binomial Option Pricing Model
Risk-Neutral Probabilities
Risk and Return of an Option
Corporate Applications of Option Pricing

Question 2

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

Answer 2

Call option -

Question 3

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

Answer 3

Put option -

Question 4

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

Answer 4

Strike price or exercise price -

Question 5

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

Answer 5

Expiration date -

Question 6

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

Answer 6

American option

Question 7

can be exercised only on the expiration date.

Answer 7

European option

Question 8

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 8

Black-Scholes Option Pricing Model

Question 9

5 Input Parameters to price the call

Answer 9

Stock Price
Strike Price
Exercise Date
Risk-free Rate
Volatility of the Stock

Question 10

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

Answer 10

Binomial Option Pricing Model

Question 11

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

Answer 11

Binomial Option Pricing Model

Question 12

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

Answer 12

Two-State Single-Period Model

Question 13

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

Answer 13

Multiperiod Model

Question 14

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

Answer 14

Risk-Neutral Probabilities

Question 15

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 15

Risk-Neutral Probabilities

Question 16

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

Answer 16

Derivative security:

Question 17

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

Answer 17

Risk-neutral pricing method:

Question 18

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

Answer 18

Risk and Return of an Option

Question 19

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

Answer 19

positive;negative

Question 20

Expected returns and beta are _____ related.

Answer 20

linearly

Question 21

two Corporate Applications of Option Pricing:

Answer 21

unlevering the beta of equity and calculating the beta of risky debt and deriving the approximation formula to value debt overhang

Question 22

Uses of Option Pricing Methods: (give 2)

Answer 22

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

Question 23

they discovered the Black Scholes Model and won the Novel Prize Award in 1997

Answer 23

Robert Merton
Myron Scholes
Fischer Black

Question 24

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 24

risk-neutral probabilities