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The Derivatives Market > Options > Flashcards

Options Flashcards

1
Q

Options

A

An option bestows upon the holder the right, but not the obligation, to buy or sell the asset underlying the option at a predetermined price during or at the end of a specific period.
Holders exercise the option only if it is rewarding to do so, and their potential profit is not finite, while there potential loss is limited to the premium paid for the option.

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2
Q

American option

A

Option that bestows the right upon the holder to exercise the option at any time before and on the expiry date of the option.

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3
Q

European option

A

Gives the holder to exercise the option only on the expiry date of the option.

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4
Q

Bermudan option

A

An option where early exercise is restricted to certain dates during the life of the option.

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5
Q

Call option

A

Bestows upon the purchaser the right to buy the underlying asset at the pre-specified price or rate from the writer of the option.

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6
Q

Put option

A

Gives the holder the option to sell the underlying asset at the pre-specified price or rate to the writer.

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7
Q

Long position

A

The buyer of the option.

Has the benefit of the option.

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8
Q

Short position

A

The seller of the option.

Also the writer of the option.

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9
Q

Naked / Uncovered

A

When the writer does not have an offsetting position in the underlying market.

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10
Q

In-the-money call

A

Price of underlying asset > strike price

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11
Q

At-the-money call/put

A

Price of underlying asset = strike price

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12
Q

Out-the-money call

A

Price of underlying asset < strike price

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13
Q

In-the-money put

A

Price of underlying asset < strike price

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14
Q

Out-the-money put

A

Price of underlying asset > strike price

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15
Q

Price / Premium (P)

A

Intrinsic value (IV) + Time value (TV)

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16
Q

Intrinsic value (IV)

A

The difference between the spot price of the underlying asset (SP) and the exercise price of the option (EP).
Only ITM puts/calls have an intrinsic value.

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17
Q

IV (call options)

A

SP - EP

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18
Q

IV (put options)

A

EP - SP

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19
Q

Time value (TV)

A

The difference between the premium (P) and the intrinsic value (IV) of the option.

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20
Q

What does time value (TV) indicate?

A

There is a probability that the intrinsic value could increase between the time of the purchase and the expiration date.

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21
Q

Delta

A

The rate of change of the option price with respect to the price of the underlying asset.

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22
Q

Theta

A

The rate of change of the portfolio value with respect to the passage of time (ceteris paribus). Also called time decay.

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23
Q

Gamma

A

The rate of change of the portfolio’s delta with respect to the price of the underlying asset.

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24
Q

Vega

A

The rate of change of the value of the portfolio with respect to the volatility of the underlying asset.

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25
Q

Rho

A

The rate of change of the portfolio value with respect to the interest rate.

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26
Q

When the holder of a call futures option exercise the option, the writer is obliged to deliver the holder of the option:

A
  • A long position in the underlying futures contract.

- Plus an amount that is equal to the difference between the last MTM futures price and the exercise price.

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27
Q

When the holder of a put futures option exercise the option, the writer is obliged to deliver the holder of the option:

A
  • A short position in the underlying futures contract.

- Plus an amount that is equal to the difference between the exercise price and the last MTM futures price.

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28
Q

The 2 basic uses of options on futures:

A
  • (Call option) To protect a future investment’s return from falling interest rates / rising prices.
  • (Put option) To protect against rising interest rates / falling prices.
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29
Q

Swaption

A

Option on the interest rate swap.

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30
Q

Call swaption

A

Imparts the right to the holder to receive the fixed rate in exchange for the floating rate.

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31
Q

Put swaption

A

The holder has the right to pay fixed and receive floating.

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32
Q

Cap contract

A

Makes it possible for a company with a borrowing requirement to hedge itself against rising interest rates.
The cap contract establishes a ceiling, but the company retains the right to benefit from falling interest rates.

33
Q

Floor contract

A

Allows a company with an investment requirement to shield itself against declining interest rates by determining a specific floor upfront, while it retains the right to profit from rising interest rates.

34
Q

Bond option

A

An option to buy (call) or sell (put) a specific bond on or before an expiry date at a pre-specified price or rate.

35
Q

Bond Index Option

A

An option to buy (call) or sell (put) a specific bond index on or before an expiry date at a pre-specified price.

36
Q

3 Total Return Indices (TRIs)

A
  • All bond index (ALBI)
  • Government Bond index (GOVI)
  • Other bond index (OTHI)
37
Q

2 Types of bond warrants

A
  • Retail options

- Call options

38
Q

Bond warrant

A

Refers to call options on specific bonds.

39
Q

Bond warrant (call option)

A

When a bond warrant (call option) is exercised, this leads to the issuer issuing new bonds.

40
Q

Bond warrant (retail options)

A

Ordinary options on specific bonds, but they are retail options (the dominations are small).
Calls and puts are written and traded and a call does not lead to the issue of new bonds.

41
Q

Callable bond

A

The buyer of the bond has sold the issuer a call option to repurchase the bond. The strike price/rate is the pre-determined price/rate that the issuer is obliged to pay to the bond holder.

42
Q

Puttable bonds

A

Bonds with embedded put options. Such bonds have provisions that allow the holder to sell the bond back to the issuer at pre-specified prices/rates on pre-determined date.

43
Q

Convertible bonds

A

Bonds that are convertible into shares at the option of the holder on pre-specified terms.

44
Q

Option on a share index

A

Allows the holder to take a position in the index for the price of the premium quoted. This means that the buyer of the share index is buying the right to “invest” in a diversified portfolio at a pre-specified price.

45
Q

Equity warrants (call options)

A

Bestow the right (option) on the holder of the warrant to take up new shares of the relevant company. These call options are usually long term in duration.

46
Q

Advantages of warrants

A
  • Warrants enable investors to trade on the JSE Limited with the same ease as trading ordinary shares
  • Warrants offer a low cost entry into blue chip shares.
  • There is potential to leverage or gear up your investments.
  • Your risk is limited to the initial premium (price of the warrant) paid.
  • Warrants have the transparency of a listed instrument.
  • Small investors can short the market or hedge their portfolios through the use of put warrants and so profit from the falls in the market.
  • The warrant market is extremely liquid, as the issuer is required to provide both bids and offers.
  • Warrants are an extremely cheap instrument to trade with no STT tax and brokerage of a flat R50 plus taxes and fees.
47
Q

Risk associated with warrants

A
  • Price risk (limited to premium)

- Credit risk

48
Q

Straddle

A

The investor believes that the price of the underlying is about to “run” but she is uncertain of the direction. It involves the purchasing of a call and a put at the same strike price and expiration date.

49
Q

Strangle

A

The investor believes that the price of the underlying is about to “run” but she is uncertain of the direction. It involves the purchasing of a call and a put at the same expiration date, but different exercise prices.

50
Q

As you like it options (AYLIO)

A

Allows the holder to convert from one type of option to another at a pre-specified point prior to expiration.
Also called “call or put option” or “chooser option”.

51
Q

Average rate options (ARO)

A

Option on which settlement is based on the difference between strike price and the average of the share or index on certain given dates.
The “average” attribute of the ARO renders the option less volatile and thus cheaper than a conventional “spot price option”.
Also called “Asian option”.

52
Q

Barrier options (BAO)

A

The payoff is dependent on the price of the underlying asset and on whether the asset reaches a pre-determined barrier at any time in the life of the option.

53
Q

Compound Options (CO)

A

Option on a option.

The buyer has the right to buy a specific option at a present date at a present price.

54
Q

Lookback options (LO)

A

Option where the pay-out is determined by using the highest intrinsic value of the underlying security or index over its life.
Look back call: Highest price.
Look back put: Lowest price.

55
Q

Quantro options (QO)

A

A currency option in terms of which the foreign exchange risks in an underlying security have been eliminated.

56
Q

Package options (PO)

A

A portfolio consisting of standard European calls, standard European puts, forward contracts, cash and the underlying asset itself.

57
Q

Forward start options (FSO)

A

Options that start their life at some stage in the future.

They are used in employee incentive schemes.

58
Q

Binary options (BIO)

A

Options with discontinuous payoffs.

59
Q

Shout options (SO)

A

European options where the holder can “shout” to the writer at one time during its life. At the end of the life of the option the holder receives either the usual payoff from the European option or the intrinsic value at the time of the shout, whichever is greater.

60
Q

Writers exercise their options only if it is rewarding to do so, and their potential loss is finite, while their potential profit is limited to the premium received for the option. True or false?

A

False. Writers do not exercise their options; holders have the right, granted to them by the writers, to exercise their options, which they will only do if it is rewarding to do so. The potential loss to the writer is not finite, while their potential profit is limited to the premium paid for the option.

61
Q

Call and put options both give the holder the right to decide whether to exercise the option. In the former case the writer is obliged to sell the underlying asset if the option is exercised, whilst in the latter case the writer is obliged to buy the underlying asset if the option is exercised.
True or false?

A

True

62
Q

The buyer of a call option takes a long option position and the buyer of a put option takes short option position. True or false?

A

False. The buyer of an option (call or put) takes a long position, i.e. s/he has bought the option and has the benefits of the option (the “option” to do something). The seller of an option (call or put) has taken a short position, i.e. s/he has sold the option and received the premium.

63
Q

The strike (or exercise) price on a put option is R500 and the premium paid was R10. On the expiration date the spot price is R495. The holder will not exercise the option because the spot price plus the premium is more than the strike price. True or false?

A

False. The holder will exercise the option because doing so will reduce the net loss from R10 (the premium) to R5. The option is bought at the spot price of R495 and sold at the strike price of R500. That gives a profit of R5 that reduces the cost of the premium of R10 by R5, leaving a net loss of R5.

64
Q

An option that is at-the-money (ATM) has no intrinsic value because SP = EP but does have time value because it has not yet reached its expiry date. True or false?

A

True

65
Q

Call options are more valuable as the SP of the underlying asset increases, and put options are more valuable as the SP of the underlying asset decreases.

A

True

66
Q

The longer the time to expiration the more valuable both call and put options are because the accrued interest calculated at the risk-free rate will be more the longer the period until maturity. True or false?

A

False. The longer the time to expiration the more valuable both call and put options are because the holder of a short-term option has certain exercise opportunities, whereas the holder of a similar long-term option also has these opportunities and more. Therefore the long option must be at least equal in value to a short-term option with similar characteristics. As noted above, the longer the time to expiration the
higher the probability that the price of the underlying assets will increase/decrease because it is probable that the fluctuation of the price can produce a spot rate that will make a bigger profit possible in future (but before expiration) than can be made today.

67
Q

The Black-Scholes option pricing model is referred to as the Midas formula, because it allows the investor to avoid all risk and obtain a true risk-free investment. True or false?

A

The Black-Scholes option pricing model is not the Midas formula, because it rests on a number of simplifying assumptions such as the underlying asset pays no interest or dividends during its life, the risk-free rate is fixed for the life of the option, the financial markets are efficient and transactions costs are zero, etc. However, it is very useful in the case of certain options.

68
Q

Define an option.

A

An option bestows upon the holder the right, but not the obligation, to buy or sell the asset underlying the option at a predetermined price during or at the end of a specified period.

69
Q

What are the types of underlying assets in the financial markets on which options can be acquired?

A

The underlying assets in the options markets of the world are other derivatives (futures and swaps), and specific instruments (“physicals”) and notional instruments (indices) of the various markets.

70
Q

What will be the profit or loss payoff of the writer of a call option if the spot price should fall below the strike (or exercise) price and if the spot price should rise above the strike price?

A

If the spot price falls below the strike price: the writer will make a profit equal to the premium. If the spot price rises above the strike price: the writer will make a loss that is unlimited in the sense that it will rise in proportion to the rise of the spot price above the strike price.

71
Q

What will be the profit or loss payoff of the holder of a put option if the spot price should fall below the strike (or exercise) price and if the spot price should rise above the strike price?

A

If the spot price falls below the strike price: the holder will make a profit that is unlimited in the sense that it will rise in proportion to the fall of the spot price below the strike price. If the spot price rises above the strike price: the holder will make a loss that is equal the premium paid on the option.

72
Q

For each of the following options, state whether it is a horizontal flip image (left flips to right and vice versa), or vertical flip image (top goes to bottom, etc.), or both a horizontal and vertical flip image of the payoff profile of call option from the perspective of the holder of a call option; writer of a call option; holder of a put option; and writer of a put option.

A

Payoff profile of the writer of a call option: a vertical flip image of the payoff profile of the holder of a call option.
Payoff profile of the holder of a put option: a horizontal flip image of the payoff profile of the holder of a call option.
Payoff profile of the writer of a put option: a horizontal and vertical flip image of the payoff profile of the holder of a call option.

73
Q

You are given the following information about a put option:
• Underlying asset = a share listed on the JSE
• Underlying asset spot market price (SP) = R243
• Option exercise price (EP) = R251
• Premium (P) = R12.
What is the time value on this option?

A

R4 {12 – (251 – 243)}

74
Q

What variable in the Black-Scholes model is the key determinant of the probability distribution of the underlying asset price? Why is this variable in the equation for the calculation of the value of a European option?

A

The volatility of the underlying asset is the key variable in the Black-Scholes model that determines the probability distribution of the underlying asset price. This is in the calculation of the value of the option as the intrinsic value of the option is the difference between the strike (or exercise) price and the (future) spot price. The former is known and fixed whereas the latter is unknown and uncertain. If the past fluctuations in the price of the underlying asset (its volatility) will be repeated in the future, it provides a statistical basis (the probability distribution) for forming an expectation of the future spot price.

75
Q

Why do the values of both puts and calls increase as volatility (of the underlying asset price) increases?

A

As volatility increases, so does the chance that the underlying asset will do well or badly. The direct investor in such an asset will not be affected
because these two outcomes offset one another over time. However, in the case of an option holder the situation is different:
• The call option holder benefits as prices increase and has limited
downsize risk if prices fall;
• The put option holder benefits as prices decrease and has limited downsize risk if prices rise.
Thus, both puts and calls increase in value as volatility increases.

76
Q

An investor requiring a general equity exposure to the extent of R1 million decides to acquire this exposure through the purchase of call options on the ALSI future. The index is currently recorded at 12 500.
Assume that the premium is R1 700 per contract. How many option contracts would the investor require? What is the investor’s breakeven price?

A

An investor requiring a general equity exposure to the extent of R1 million decides to acquire this exposure through the purchase of call options on the ALSI future. The index is currently recorded at 12 500, s/he would require 8 call option contracts (8 x R10 x 12500 = R1 000 000) (remember that one ALSI futures contract is equal to R10 times the index value).Because the investor is buying the right to purchase the future and has no obligation in this regard, s/he pays a premium to the writer. The premium is R1 700 per contract (R13 600 for 8 contracts). The investor is thus paying R13 600 for the right to purchase 8 ALSI futures contracts at an exercise or strike price of 12500 on or before the expiry date of the options contract. It will be evident that the premium per contract of R1 700 translates into 170 points in the all share index (R1 700 / R10 per point). Thus, the investor’s breakeven
price is 12670 (12500 + 170).

77
Q

The premium on a 3-month JIBAR September future, with a price of R94.60, is 8.5% in June. An investor buys a call option on this future in June for a nominal value of R1 000 000. By the expiry date interest rates have fallen to 5.2%. Will the holder exercise the option and what is the profit or loss on the option?

A

The holder of the option has the right to make a deposit of R1 000 000 on the expiry date in September (the date is specified) at an interest rate
of 5.4% (100 – 94.60) for 3 months. Each tick movement on the contract, which is equivalent to one basis point, is worth the value of the contract (R1 000 000) multiplied by 1 basis point (0.01% or 0.0001) and a quarter of a year (0.25), i.e.: R1 000 000 x 0.0001 x 0.25 = R 25.00. The cost of the call option (i.e. the premium), is therefore 8.5 x R25.00 = R212.50.
If by the expiry date the contract strike price rises to R94.80% (interest rates have fallen to 5.2%) the holder is entitled to a gain of 20 basis points, and the profit is 20 x R25.00 = R500.00 less the premium of R212.50 = R287.50. The holder will therefore exercise the option to make a profit of R287.50.

78
Q

An investor has a portfolio that can be compared with the JSE’s ALSI share index. The value of his portfolio is R5.5475 million and the ALSI index is presently standing at 15 850. The value of a share index option is ten times the index value. How many put options will the investor require to hedge the value of his portfolio?

A

The value of his portfolio is R5.5475 million and the ALSI index is presently standing at 15 850. The value of a share index option is ten times the index value. The value of each option is thus 15 850 x R10 = R158 500. The investor will buy 35 put options on the ALSI index (35 x 158 500 = 5 547 500).

79
Q

What is the delta of an option?

A

Delta is the rate of change of the option price with respect to the price of the underlying asset

The Derivatives Market (7 decks)

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