LM 8: Pricing & Valuation of Options

Question 1

What is the exercise value of a call and put formula?

Answer 1

cT = max ( 0 , sT - X)
pT = max ( 0, X - sT)

st = price of underlying asset
x = strike price or exercise price

Question 2

What is the exercise value of a call and put formula if option were to be exercised before maturity?

Answer 2

exercise value (call) = max (0, sT - (X/ ((1+r)^(T-t))

exercise value (put) = max (0, X/ ((1+r)^(T-t)) -sT

st = price of underlying asset
x = strike price or exercise price
r = risk free rate
T - t = time remaining until maturity

Question 3

What is in the money, out of the money, and at the money?

Answer 3

in the money = stock price > exercise price
out of money = stock price < exercise price
at the money = stock price = exercise price

Question 4

Whats the equation for the options time value?

Answer 4

difference between current price and exercise value

Current price - exercise value

Question 5

What is the difference between payoff and profit for options?

Answer 5

payoff = how much profit not counting premiums

profit = how much profit counting premiums

Question 6

What are 6 factors that affect an options value? VETRVI

Answer 6

1. value of underlying
2. exercise price
3. time to expiration
4. risk free interest rate
5. volatility of underlying
6. income or costs related to owning the underlying

Question 7

What is the relationship between the value of the underlying and a call vs a put option?

Answer 7

Call Option: directly related (as underlying increases option increases)

Put Option: inversely related (as underlying increases option decreases)

Question 8

What is the relationship of the exercise price vs a call option and a put option?

Answer 8

Call Option: inverse relationship (if exercise price decreases call option becomes more valuable & vice versa)

Put Option: direct relationship (if exercise price increases value of put option increases & vice versa)

Question 9

What is the relationship between risk free interest rate vs the European call and European put?

Answer 9

European Call: directly related (as risk free rate rises value of European call rises) (higher risk free rate makes underlying more valuable)

European Put: inversely related (as risk free rate rises value of European put decreases)

Question 10

Who benefits from increased volatility?

Answer 10

both put and call option holders

Question 11

What is the relationship between increased benefits of owning the underlying assets and the value of a put or call?

Answer 11

Call option: reduce value of calls

Put option: increases value of puts