Module 49.3: Option Valuation and Put-Call Parity

Question 1

When is an option in and out of the money?

Answer 1

if immediate exercise will create profits, the option is in the money and vice versa

Question 2

What is the intrinsic value of an option? Wahat is the time value of an option?

Answer 2

maximum of zero and the amount that the option is in the money

time value is the amount by which the option premium exceeds the intrinsic value

option premium = intrinsic value + time value

Question 3

What are the six factors that determine option prices?

Answer 3

1) price of underlying
2) the exercise price
3) risk free rate of interest
4) volatility of the underlying
5) time to expiration
6) costs and benefits of holding the asset

Question 4

Explain how the price of underlying asset affects option price?

Answer 4

Increase / decrease in price will increase / decrease the intrinsic value of an option

Question 5

Explain how the exercise price affects option price?

Answer 5

higher exercise price decreases the values of call options and increases the value of put options.

Question 6

Explain how the risk free rate of interest affects option price?

Answer 6

increase in risk free rate will increase call option values and vice versa.

Question 7

Explain how volatility affects option price?

Answer 7

time or speculative value would always be 0 if no volatility. less time to expiration reduces value for a call option and increases for a put.

Question 8

Explain how costs and benefits affects option price?

Answer 8

dividends or interest will reduce the call value and increase put. reason being is that dividends reduce value of underlying. positive holding costs (storage) make a call more valuable because you get exposure to the stock without paying.

Question 9

What is a fiduciary call and a protective put?

Answer 9

fiduciary call - combo of a call with exercise price X and a discount riskless bond that pays X at maturity

Protective put - share of stock with a put option on the stock.

Question 10

What is the payoff of a fiduciary call when it is out / in the money?

Answer 10

Out = X (exercise price)

In = X + (S - X) = S

S = stock price
X = exercise price

Question 11

What is the payoff of a protective put when it is out / in the money?

Answer 11

Out = S

In = (X -S) +S = X

S = stock price
X = exercise price

Question 12

If at payoff S is greater than X or X is greater than S, is the payoff of a fiduciary call and protective put the same?

Answer 12

yes

Question 13

What is the put -call parity relationship formula for European options?

Answer 13

c + X / (1 +rf)^T = S + p

c = call price
X = exercise price 
S = stock price
p = put price

Question 14

What is the formula for put call parity relationship for forward contracts

Answer 14

F0(T) / (1 + rf)^T + p0 = c0 + X / (1+rf)^T

or

p0 - c0 = [X - F0(T)] / (1 + rf)^T

Question 15

Explain why longer time to expiration for euripean style puts may not increase the value of put options as expected?

Answer 15

when there is a long time to expiration, high Rf, deep in-the-money)