Topic 13 Intro to Options

Question 1

Call Option

Answer 1

-Gives owner right to purchase an asset for a specified price at or before an expiration date
-Buyer/Owner/Holder vs Seller/Writer
Premium=amount the buyer of the call pays the seller aka price of the call

Question 2

Payoff

Answer 2

-net cash flow to the seller of the option if option exercised at time, T
-It includes only the cash exchanged at time, T
-It is identical to all owners of the option at time, T

Question 3

Profit-includes the premium

Answer 3

=Net cash flow to the owner of the option at time, T plus the premium paid at time 0
-owners of the option may have different profits at T as may have purchased/sold at different times and prices
-ignore TVM, acct profit

Question 4

“Moneyness”

Answer 4

-relates to payoff for owner
In the money=would exercise option as payoff is positive
At the money= indifferent about exercising option; zero payoff
out of the money= would not exercise the option as payoff would be negative

Question 5

American versus European

Answer 5

American-owner has right to exercise at any time; FREEDOM MF
European: only at expiration date

Question 6

Covered Call

Answer 6

Write a call + Long/Buy Stock -> IF the option is exercised and need to deliver stock, the seller of the call is “covered” bc they own the stock already

Question 7

Protective Put

Answer 7

Buy Put + Long/buy Stock -> If the stock price decreases, can exercise the put; kind of puts a floor on loses

Question 8

Long Straddle

Answer 8

Buy Put + Buy Call with same T and X -> if stock price decreases can exercise the put. IF increases a lot can exercise the call; “protects” you from big changes in stock price

Question 9

Replicating Portfolio

Answer 9

Buy a call + Write Put at same X and T + invest X/(1+r)^T in a riskless bond
-By doing so one can create “synthetic stock” -> must equal value of stock to avoid arbitrage

Question 10

European Put-Call Parity

Answer 10

-Own a call, buy a stock on margin
Call-Put+PV Risk Free = Stock
*Can therefore price call based on value of put stock and RF and vice versa

Question 11

European Put-Call Assumptions:

Answer 11

1) European options
2) Options must have same exercise price
3) assumes that other options, stocks, and bonds are fairly priced
4) Stock makes no dividend payments

required to depsoit X+Div for stocks dividends on replicating portfolio