Options and Binomial Pricing

Question 1

Define a call option

Answer 1

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

Question 2

Define a put option

Answer 2

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

Question 3

Difference between European and American style options

Answer 3

European options can be exercised only at maturity.
American options can be exercised anytime up to maturity

Question 4

Where are options traded

Answer 4

Options are traded both on exchanges and over-the-counter

Question 5

Exchange-traded options are fairly standardized with respect to:

Answer 5

Strike prices (usually scattered around the current stock price).
Delivery date (e.g. the 3rd Friday during the month).
Contract size, and so on.

Question 6

Put call parity assumptions

Answer 6

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

Question 7

Bear spread strategy

Answer 7

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

Question 8

Bull spread strategy

Answer 8

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

Question 9

Straddle strategy

Answer 9

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.

Question 10

Strap strategy

Answer 10

Buy two calls and one put with the same strike price and expiration date

Question 11

What is a calendar spread

Answer 11

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.

Question 12

What is a covered call

Answer 12

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

Question 13

How do cash dividends effect the value of an option

Answer 13

Cash dividends unless they are unusually large have no effect on the terms of an option.

Question 14

When the time to maturity increases with all else remaining the same, what happens to the value of an option

Answer 14

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.

Question 15

In a binomial tree created to value an option on a stock, what is the expected return on the option

Answer 15

The risk-free rate

Question 16

How does expected return influence the option value

Answer 16

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.

Question 17

What is the intrinsic value of an option

Answer 17

The value it would have if the owner had to exercise it immediately or not at all