L4 and 5 - financial options Flashcards
Define a call option
A call option gives the holder the right (not the obligation) to buy an asset at a pre-specified time for a pre-specified price
Define a put option
A put option gives the holder the right (not the obligation) to sell an asset at a pre-specified time for a pre-specified price
Difference between European and American style options
European options can be exercised only at maturity.
American options can be exercised anytime up to maturity
Where are options traded
Options are traded both on exchanges and over-the-counter
Exchange-traded options are fairly standardized with respect to:
Strike prices (usually scattered around the current stock price).
Delivery date (e.g. the 3rd Friday during the month).
Contract size, and so on.
Put call parity assumptions
1 There are no transaction costs.
2 All trading profits are subject to the same tax rate.
3 Borrowing and lending are possible at the risk-free rate.
4 There are no arbitrage opportunities
If the put-call parity is violated there are arbitrage opportunities
Bull spread strategy
expect market will go up.
Buy a European call with a strike price K1.
Sell a European call with a strike price K2 > K1.
Both calls have the same expiration date
Bear spread strategy
expect market will go down
Sell a European put with a strike price K1.
Buy a European put with a strike price K2 > K1.
Both puts have the same expiration date
Straddle strategy
Market is volatile but you don’t know which way it will move
Buy a European call with a strike price K.
Buy a European put with a strike price K.
Both options have the same expiration date and the same strike price.
Strap strategy
Buy two calls and one put with the same strike price and expiration date
What is a calendar spread
A calendar spread is created by buying an option with one maturity and selling an option with another maturity when the strike prices are the same and the option types (calls or puts) are the same.
What is a covered call
A covered call consists of a short call plus a long position in the stock. The if the call is exercised the owner of the position has the stock ready to deliver if the other side exercises the call
How do cash dividends effect the value of an option
Cash dividends unless they are unusually large have no effect on the terms of an option.
When the time to maturity increases with all else remaining the same, what happens to the value of an option
When the time to maturity increases from X to Y, European options usually increase in value. But they can decrease in value if a big dividend expected between X and Y.
In a binomial tree created to value an option on a stock, what is the expected return on the option
The risk-free rate
How does expected return influence the option value
The option price when expressed in terms of the underlying stock price is independent of the return on the stock. To put this another way, everything relevant about the expected return is incorporated in the stock price.
What is the intrinsic value of an option
The value it would have if the owner had to exercise it immediately or not at all
Explain why margins are required when clients write options but not when they buy options
When buying an option, cash is paid upfront meaning there is no possibility of future liabilities therefore no need for a margin
whereas when selling an option there is
A company declares a 2-for-1 stock split. Explain how the terms change for a call option with a strike price of $60
Strike reduces to $30, and the option gives the holder the right to
purchase twice as many shares.
Explain why an American option is always worth at least as much as
its intrinsic value
The holder of an American option has the right to exercise immediately. The American option must therefore be worth at least as much as its intrinsic value
Explain why the arguments leading to put–call parity for European options cannot be used to give a similar result for American options
When early exercise is not possible, we can argue that two portfolios that are worth the same at time must be worth the same at earlier times. When early exercise is possible, the argument falls down
What is a protective put
A protective put consists of a long position in a put option combined with a long position in the underlying shares
How can a forward contract on a stock with a particular delivery price and delivery date be created from options
Buying a call and selling a put gives us a guaranteed payoff
strip strategy
Buy two puts and one call with the same strike price and expiration date
What is meant by the delta of a stock option
The delta of a stock option measures the sensitivity of the option price to the price of the stock when small changes are considered. Specifically, it is the ratio of the change in the price of the stock option to the change in the price of the underlying stock.
The price of an American call calculated by using the binomial tree method is £10. Consider now
that the real-world probability of an upward movement changes and is higher by 50% than before.
Will the American call price increase, decrease or remain unchanged? Explain your answer.
The price will remainn unchanged. To value the option we use risk-neutral (and not real-world) probabilities. The real-world probabilities of an up and a down move are not relevant for valuing the option. This is because we are valuing the option in relative terms (and not absolute terms).
More specifically, we value the option in terms of the underlying asset price and hence, the real world probabilities of up- & down- movements are already incorporate in the underlying asset price.
