Semi Fi: G6: Financial Option Valuation Techniques

Question 1

1997 Nobel Prize (Black-Scholes Option Pricing Model)

Answer 1

Robert Merton
Myron Scholes
Fischer Black

Question 2

Common techniques, derived from black and scholes’ insights

Answer 2

Black-Scholes option pricing model
Binomial option pricing model
Risk-neutral probabilities
Risk and return of an option
Corporate applications of option pricing

Question 3

Gives holder the right (but not the obligation) to purchase an asset at some future date

Answer 3

Call option

Question 4

Gives the holder the right to sell an asset at some future date

Answer 4

Put option

Question 5

The price at which the holder agrees to buy or sell the share of stock when the option is exercised

Answer 5

Strike price or exercise price

Question 6

The last date on which the holder has the right to exercise the option

Answer 6

Expiration date

Question 7

Can be exercised on any date up to, and including the exercise date

Answer 7

American option

Question 8

Can be exercised only on the expiration date

Answer 8

European option

Question 9

It can be derived from the binomial option pricing model by making the length of each period, and the movement of the stock price per period, shrink to zero and letting the number of periods grow infinitely large

Answer 9

Black-Scholes option pricing model

Question 10

Five input parameters to price the call

Answer 10

Stock price
Strike price
Exercise date
Risk-free rate
Volatility of the stock

Question 11

An option can be valued using a portfolio that replicates the payoffs of the option in different states

Answer 11

Binomial option pricing model

Question 12

It assumes two possible states for the next time period, Given today’s state.

Answer 12

Binomial option pricing model

Question 13

The value of an option is the value of the portfolio that replicates it’s payoffs. The replicating portfolio will hold the underlying asset and risk free debt, and will need to be rebalanced overtime.

Answer 13

Binomial option pricing model

Question 14

A portfolio of other securities that has exactly the same value in one period as the option.

Answer 14

Two-state single-period model

Question 15

There are more than two possible outcomes for the stock price in the real world

Answer 15

Multiperiod Model

Question 16

Also known as state-contingent prices, state prices, or Martingale prices

Answer 16

Risk-neutral probabilities

Question 17

Probabilities under which the expected return of all securities equals the risk free rate. These probabilities can be used to price any other asset for which the beat of in each state are known.

Answer 17

Risk-neutral probabilities

Question 18

In a binomial tree, the risk-neutral probability p that the stock price will increase is given by

Answer 18

Risk-neutral probabilities

Question 19

Risk-neutral probabilities formula

Answer 19

P = (1 + rf ) x S - Sd
Divide by Su - Sd

Question 20

Any security whose pay-off depends solely on the prices of other marketed assets

Answer 20

Derivative security

Question 21

The basis for a common technique for pricing derivative securities called Monte Carlo simulation

Answer 21

Risk-neutral pricing method

Question 22

True or false

In the randomization, the risk-neutral probabilities are used, and so the average payoff can be discounted at the risk-free rate to estimate the derivative security’s value

Answer 22

True

Question 23

Probability call option formula

Answer 23

Pc = P x (Su - K )
Divide by (1 + rf )

Question 24

Probability put option formula

Answer 24

Pp = P x (K - Sd)
Divide by (1 + rf )

Question 25

True or false
The beta of an option can also be calculated by completing the beta of its replicating portfolio

Answer 25

True

Question 26

For stocks with positive betas, calls will have larger betas than the underlying stock, while puts will have negative betas. The magnitude of the option bed that is higher for options that are further out of the money.

Answer 26

Risk and return of an option

Question 27

True or false
For stocks with negative betas, calls will have larger Betas than the underlying stock, while puts will have negative betas.

Answer 27

False

Question 28

As the stock price changes, the beta of an option will change

Answer 28

Risk and return of an option

Question 29

Two corporate applications of option pricing

Answer 29

1. Unleveraging the beta of equity, and calculating the beta of a risky debt
2. Deriving the approximation formula to value debt overhang

Question 30

True or false

When debt is risky, the betas of equity and debt increase with leverage

Answer 30

True

Question 31

True or false

When debt is risky, the betas of equity and debt decrease with leverage

Answer 31

False

Question 32

Uses of option pricing methods

Answer 32

Assess potential investment distortions that might arise due to debt overhang or the incentive for asset substitution and risk-taking

Evaluate state–contingent costs, such as financial distress costs

Enhance the value of the firm