Option Valuation

Question 1

what is the strike price?

Answer 1

prespecified price/excerise price

Question 2

what is a call option?

Answer 2

entitles the owner of the option to buy a stock at a prespecified price (strike price), at/before the maturity of the option.

Question 3

what is a put option?

Answer 3

entitles the owner of the option to sell stock at a prespecified price (strike price), at/before the maturity of the option.

Question 4

What does “in the money” mean for call and put options?

Answer 4

Call: the price of the stock is higher than the exercise price
Put: when the price of the stock is below the exercise price

Question 5

what does “out of the money” mean?

Answer 5

the opposite

Question 6

when stock price is equal to exercise price the term used is?

Answer 6

at the money

Question 7

in regards to options what is the difference between short and long?

Answer 7

long: is buying a put or call option
Short: is selling a put or call option

Question 8

for the diamond diagram for pay offs what is the order?

Answer 8

Long call long put

short call short put

Question 9

what are long options more attractive than short options?

Answer 9

long: you make a gain or don’t exercise
short: you profit from selling the option, however you also stand to make a loss if you are forced to buy stocks at inflated prices or sell them cheaper

Question 10

what is the intrinsic value of a call or a put option?

Answer 10

Call: max(stock price - exercise price, or 0)
Put: max (exercise price - stock price, or 0)
when value is negative we allow option to lapse

Question 11

what is the time value of an option?

Answer 11

this extra value is the risk that the stock price will change by the time we excercise.

Question 12

explain the different roles of a buyer and seller of options? ie their entitlements.

Answer 12

• the buyer of an option has the right to buy or sell stock at the exercise price.
• the seller of an option has the obligation to buy or sell stock at the exercise price, if the buyer of the option wishes to exercise their option.

Question 13

What is another factor which increases the value of a call option?

Answer 13

was the variability in stock price increase and the time to expiration increases so to does the option vale.

Question 14

As stock prices increase the value of a call option will?

Answer 14

increase (opposite for put)

Question 15

As exercise price increases the value of a call option will?

Answer 15

decrease (opposite for put)

Question 16

As interest rates increase the value of a call option will?

Answer 16

increase (opposite for put)

Question 17

As time to expiration increases the value of a call option will?

Answer 17

increase

Question 18

As volatility of stock prices increase the value of a call option will?

Answer 18

increase

Question 19

notes on U, Rf and D

Answer 19

U>R>D

Question 20

whats the difference between american and european options?

Answer 20

you can excerise american options early while euro you can only exercise at maturity.

Question 21

how can you value an american option?

Answer 21

by first finding the euro option value and then comparing the option value to the euro value and the strike price, if the option value is greater than the euro value you exercise it early.

Question 22

what happens if R, D or U share a value?

Answer 22

there is a possibiliy for arbitrage

Question 23

what are the 4 fundamental statements of asset pricing?

Answer 23

• asset markets are arbitrage free
• asset markets are complete
• there exisits unique risk nuetral probabilities
• there exists positive state prices