Topic 4 - Options and Corporate Finance: Basic Concepts

Question 1

What does an option contract gives the holder the right to do?

Answer 1

gives the holder the right, but not the obligation, to buy or sell a given quantity of an underlying asset on (or before) a given date, at a price agreed upon today

Question 2

whats the difference between European versus American options?

Answer 2

• European options can be exercised only at expiry
• American options can be exercised at any time up to
  expiry

Question 3

What does the difference in EU vs US options mean for their value?

Answer 3

an American option can never be worth less than a European option that is otherwise the same - because early exercise could be a valuable opportunity

Question 4

What does a call option do?

Answer 4

A Call option gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at a price agreed upon today

Question 5

What does a put option do?

Answer 5

A Put option gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at a price agreed upon today

Question 6

When is a call in/out of the money?

Answer 6

• In-the-Money if S0 > E

- Out-of-the-money if S0

Question 7

When is a put in/out of the money?

Answer 7

• In-the-Money if S0 E

Question 8

what are the Components of Option Value? (2)

Answer 8

intrinsic and time value

Question 9

What is intrinsic value?

Answer 9

The difference between the exercise price of the option and the spot price of the underlying asset.

Question 10

What is the time value of an option?

Answer 10

The difference between the option premium (i.e., price) and the intrinsic value of the option

Question 11

what is the formula for intrinsic value of call and put option?

Answer 11

C = S -E
P = E -S

Question 12

what is the formula for time value for both call and puts?

Answer 12

Time value = C - Intrinsic value

Question 13

who bares more risk the call/put holder or the call/put seller?

Answer 13

The holder does not bear risk – if the stock price goes down/up the option is allowed to expire unexercised

Question 14

When is a US put/call option equal to a EU put/call option, with the same characteristics?

Answer 14

at expiry as there is no more time value

Question 15

What is a Protective Put strategy?

Answer 15

Buy stock and buy put to protect against price decrease

Question 16

What is a covered call strategy?

Answer 16

Buy stock, sell call to reduce the cost of buying stock

Question 17

What is a long straddle and what is a short straddle?

Answer 17

Long: buy call and buy put
Short: Sell call and sell put

Only makes money if the price moves in one or the other direction by the sum of the cost of both the call and the put.

Question 18

What is the put call party?

Answer 18

If the value of one option is known, the other can be determined without resorting to direct valuation
if they have the same exercise price and term to expiry.

Question 19

If a put is under priced what should you do to make an arbitrage profit?

Answer 19

buy put
exercise put (sell stock)
buy stock

Question 20

If a call is under priced what should you do to make an arbitrage profit?

Answer 20

buy call
exercise call (buy stock)
sell stock

Question 21

what are five things that can impact on the value of an american put option?

Answer 21

• The price of the underlying asset (decrease put)
• The strike price of the option.
• The time to expiration of the option.
• The volatility of the underlying asset.
• The interest rate (decrease put)