Options contracts Part A

Question 1

What is an Option Contract

Answer 1

An option is a contract that gives the buyer the right, but not the obligation to buy or sell an asset at a predetermined price (exercise price) to the seller of the option:

In other words, the buyer (holder, or person in the long position) has a right to exercise (or to enforce the contract), but the seller (writer, or person in the short position) must comply with the buyer’s decision

Question 2

why is an option a type of derivative security?

Answer 2

Options represent a claim on an underlying asset

Question 3

An option contract normally specifies:

Answer 3

1. a call or put option
2. exercise or strike price
3. maturity or expiration date
4. specific asset underlying the option contract
5. amount of the asset
6. American or European in nature

Question 4

an option contract normally specifies

call option or put option

distinguish between the two

Answer 4

Whether the option gives the buyer a right to buy the underlying asset (a call option) at the exercise price or a right to sell the underlying asset (a put option) at the exercise price;

Question 5

an option contract normally specifies

exercise or strike price

Answer 5

X (i.e. the price at which the asset may be bought / sold by the option holder)

Question 6

an option contract normally specifies

maturity or strike date

Answer 6

which is the terminating date of the option. The time to expiry is denoted T

Question 7

an option contract normally specifies

the amount of the asset….

Answer 7

The amount of the asset that may be bought or sold under the option contract

Question 8

call option

what does it give the holder?

Answer 8

It gives the holder (the person in the long position) the right but not the obligation to buy the asset underlying the contract;

Question 9

call option

the writer of the option is

Answer 9

The writer of the option (the person in the short position) is obliged to sell the asset if the holder exercises their right to buy it under the option contract

Question 10

call option

distinguish between a European and an American call option

Answer 10

If the option can only be exercised by the holder at expiry, it is known as a European call option.

If the option can be exercised by the holder at any time before expiry or at expiry, it is known as an American call option

Question 11

put option

gives the holder

Answer 11

It gives the holder (the person in the long position) the right but not the obligation to sell the asset underlying the contract;

Question 12

put option

the writer of the put option

Answer 12

the writer of the option (the person in the short position) is obliged to buy the asset if the holder exercises their right to sell it under the option contract

Question 13

distinguish between American and European put options

Answer 13

If the option can only be exercised by the holder at expiry, it is known as a European put option.

If the option can be exercised by the holder at any time before expiry or at expiry, it is known as an American put option

Question 14

when will call options be exercised?

Answer 14

When the price the holder can buy for in the spot market, S, is greater than the price they would pay for the asset under the option, X

Question 15

when will put options be exercised?

Answer 15

When the price the holder can sell for in the spot market, S, is less than the price they would sell for the asset under the option, X

Question 16

When the holder exercises a call option, the gain (payoff) the holder makes from the option can be expressed

Call Option

Answer 16

(S_T-X) if S_T>X, 0 otherwise (as the holder won’t exercise the option if S_Tout of the money). In other words, the payoff is max (S_T-X,0)

Question 17

When the holder exercises a put option, the gain (payoff) the holder makes from the option can be expressed

Put Option

Answer 17

(X-S_T) if X>S_T, 0 otherwise (as the holder won’t exercise the option if X because it is out of the money). In other words, the payoff is max (X-ST,0).

Question 18

payoff for the writer of the option or the person in the short position

call option

Answer 18

-(S_T-X), or (X- S_T), if S_T>X, 0 otherwise (as the holder won’t exercise the option)

Question 19

payoff for the writer of the option or the person in the short position

Put Option

Answer 19

-(X-ST), or (ST-X) if X> ST, 0 otherwise (as the holder won’t exercise the option)

Question 20

what do payoff diagrams show?

Answer 20

the payoff for the holder is the exact opposite of the payoff for the writer of the option

Question 21

Payoff from a long position in a European call option

Answer 21

Question 22

pay off from a short position in a European Call option

Answer 22

Question 23

pay off from a long position in a European PUT option

Answer 23

Question 24

payoff from a short position in a European PUT option

Answer 24

Question 25

the holder of the option will only exercise the option if it benefits them this is when

Answer 25

holder of the option will only exercise the option if it benefits them (i.e. their minimum payoff is 0) and

the payoff for the writer is the exact opposite of the holder’s payoff (i.e. their maximum payoff is 0)