Week 1 Flashcards
What is an option
A contract that gives the holder the right, but not the obligation, to buy or sell a financial asset at a predetermined price and time
Difference between American and European options
European can be exercised only on expiry date, American can be exercised at any point up to expiry date
General formula for call option
(S-K)+ = max{S-K, 0}
Where
S = New price
K = Strike price
+ means all neg values go to zero
General formula for put option
(K-S)+ = max{K-S, 0}
Where
S = New price
K = Strike price
+ means all neg values go to zero
A market with 2 assets:
Equation for value of 2 asset portfolio at time 1
Show simple tree for portfolio of 2 assets
Criteria for arbitrage
1) V_0 = 0, (free to enter)
2) P(V_1>=0)=1 (can’t lose)
3) P(V_1>0)>0 (can win)
Single statement that prevents arbitrage in a 2 asset binomial market when satisfied
2 pricing assumptions of course
Can divide each asset infinitely
Buy = Sell
Find fair value for portfolio of 2 assets
Mistake I made in option notation
I was using - sign for puts
