Options, Futures and Other Derivatives Ch1

Question 1

What is the underlying asset in a derivative contract?

Answer 1

The asset on which the value of the derivative is based, such as stocks, bonds, commodities, or indices.

Question 2

Explain the concept of counterparty risk.

Answer 2

The risk that one party in a derivative transaction may default on its obligations, leading to financial losses for the other party.

Question 3

Differentiate between over-the-counter (OTC) and exchange-traded derivatives.

Answer 3

Exchange-traded derivatives are standardized contracts traded on organized exchanges, while OTC derivatives are customized contracts traded directly between parties.

Question 4

Define the term “margin” in futures trading.

Answer 4

A deposit made by both the buyer and the seller in a futures contract to ensure performance. It acts as collateral against potential losses.

Question 5

What is the role of clearinghouses in futures trading?

Answer 5

Clearinghouses act as intermediaries, ensuring the performance of futures contracts by guaranteeing trades and managing margin requirements.

Question 6

Explain the concept of arbitrage in derivatives markets.

Answer 6

Arbitrage involves profiting from price differences between related securities or assets by simultaneously buying and selling to exploit the discrepancy.

Question 7

What are the key factors that influence the value of an option?

Answer 7

Underlying asset price, strike price, time to expiration, volatility, risk-free interest rate, and dividends.

Question 8

What is the intrinsic value of an option?

Answer 8

The difference between the current price of the underlying asset and the strike price of the option, if it’s favorable.

Question 9

Define time value in options.

Answer 9

The portion of an option’s premium that exceeds its intrinsic value, representing the possibility of the option gaining additional value before expiration.

Question 10

Explain the concept of at-the-money (ATM) options.

Answer 10

Options where the strike price is equal to the current market price of the underlying asset.

Question 11

What is the relationship between option prices and volatility?

Answer 11

Higher volatility generally leads to higher option prices due to increased uncertainty and potential for larger price movements.

Question 12

Define the term “delta” in options.

Answer 12

Delta measures the sensitivity of an option’s price to changes in the price of the underlying asset.

Question 13

Explain the concept of gamma in options.

Answer 13

Gamma measures the rate of change in an option’s delta in response to changes in the price of the underlying asset.

Question 14

What is theta in options?

Answer 14

Theta measures the rate at which an option loses value as time passes and expiration approaches, also known as time decay.

Question 15

Define vega in options.

Answer 15

Vega measures an option’s sensitivity to changes in volatility.

Question 16

Explain the concept of risk-neutral valuation.

Answer 16

A method used to value derivatives assuming a risk-free rate, allowing for simplified pricing and hedging.

Question 17

Define put-call parity.

Answer 17

An equation that shows the relationship between the prices of European put and call options with the same strike price and expiration date.

Question 18

What are the key differences between European and American options?

Answer 18

European options can only be exercised at expiration, while American options can be exercised at any time before expiration.

Question 19

What are the advantages of using derivatives?

Answer 19

Risk management, hedging, speculation, and leveraging investment positions.

Question 20

Explain the concept of a forward price in futures contracts.

Answer 20

The price at which the underlying asset will be traded on the delivery date in a forward or futures contract.

Question 21

What role do speculators play in derivatives markets?

Answer 21

Speculators take positions in derivatives with the intention of profiting from price changes, increasing market liquidity and efficiency.

Question 22

Define basis risk in derivatives trading.

Answer 22

The risk that the relationship between the price of the derivative and the underlying asset may change, leading to potential losses.

Question 23

Explain the concept of contango in futures markets.

Answer 23

Contango occurs when future prices of a commodity or asset are higher than the current spot price, often seen in markets with high demand and low supply.

Question 24

What is backwardation in futures markets?

Answer 24

Backwardation occurs when future prices of a commodity or asset are lower than the current spot price, indicating immediate demand or scarcity.

Question 25

Define the term “convergence” in futures markets.

Answer 25

Convergence is the process where futures prices gradually approach the spot price as the contract’s expiration date nears.

Question 26

What is the impact of dividends on options pricing?

Answer 26

Dividends can affect the price of the underlying asset, thus impacting the price and value of options.

Question 27

Explain the concept of volatility smile in options markets.

Answer 27

Volatility smile represents the pattern where options with the same expiration date but different strike prices have different implied volatilities.

Question 28

Define implied volatility in options.

Answer 28

Implied volatility is the market’s expectation of the future volatility of the underlying asset, inferred from the option’s price.

Question 29

What is the Black-Scholes-Merton model?

Answer 29

A mathematical model used for pricing European-style options, considering factors like stock price, strike price, time to expiration, risk-free interest rate, and volatility.

Question 30

Explain the limitations of the Black-Scholes-Merton model.

Answer 30

Assumptions such as constant volatility, no dividends, and efficient markets might not always reflect real-world conditions accurately.

Question 31

What is the role of financial institutions in derivatives markets?

Answer 31

Financial institutions often act as intermediaries, facilitating derivative transactions for clients, managing risk, and providing liquidity.

Question 32

Define the term “notional amount” in derivatives.

Answer 32

The nominal or face value of the underlying asset used to calculate payments or obligations in a derivative contract.

Question 33

Explain the concept of a derivative as a zero-sum game.

Answer 33

In derivative contracts, gains for one party are equal to the losses of the other, making it a zero-sum game.

Question 34

What is the significance of regulation in derivatives markets?

Answer 34

Regulation aims to promote market integrity, transparency, and stability, ensuring fair practices and reducing systemic risks.

Question 35

Define the term “mark-to-market” in derivatives.

Answer 35

The process of valuing positions based on current market prices, reflecting changes in the value of assets or contracts.

Question 36

What is the importance of risk management in derivatives trading?

Answer 36

Effective risk management helps in controlling potential losses, maintaining financial stability, and ensuring compliance with regulatory requirements.

Question 37

What is the Black-Scholes formula used for?

Answer 37

The Black-Scholes formula is used to calculate the theoretical price of European call and put options using factors like stock price, strike price, time to expiration, risk-free rate, and volatility.

Question 38

Provide the Black-Scholes formula for the price of a call option.

Answer 38

Question 39

Provide the formula for the calculation of d1 in the Black-Scholes model.

Answer 39

Question 40

What is the put-call parity equation?

Answer 40

Question 41

Explain the concept of delta in options and provide its formula.

Answer 41

Question 42

What is the formula for gamma in options?

Answer 42

Question 43

Explain the concept of vega in options and provide its formula.

Answer 43

Question 44

Explain the concept of theta in options and provide its formula.

Answer 44

Question 45

Define the concept of the risk-free rate in options pricing and provide its significance in formulas.

Answer 45

The risk-free rate is the theoretical return on an investment with zero risk. It’s used in options pricing models as it determines the present value of future cash flows, influencing option prices through discounting.

Question 46

Explain the concept of volatility skew in options and its implications.

Answer 46

Volatility skew refers to the differing implied volatility levels across various strike prices or expiration dates within an options chain. It implies differing market perceptions of potential price movements.

Question 47

Provide the formula for the calculation of implied volatility using the Black-Scholes model.

Answer 47

Implied volatility is often calculated by using the Black-Scholes model backward, solving for volatility when given the observed option price.