Week 9 - Put & call options

Question 1

Call option
Put option
European put/call option
American put/call option

Answer 1

Call option
- gives the owner the right, but not the obligation to BUY the underlying asset @ a specified strike price K, at a specified maturity date T
Put option
- same thing except the right to SELL

Question 2

Long position in a call
Short position in a call
Long put option
Short put option

^different ways to express. Show the shape of the payoff diagrams

Answer 2

See notes

Question 3

4 option strategies & when investors use them

Answer 3

1. Straddle
   - when investor believes that the stock is VOLATILE (will move significantly) but have no particular opinion of which direction the stock price will move
   - investor can get payoff regardless of where ST moves
   - for speculation
2. Reverse straddle
   - when investor believes that the stock has LITTLE VOLATILITY & believes that ST will be close to EXERCISE PRICE K
   - for reverse speculation
3. Bull spread using calls
   - if investor has a MILDLY BULLISH VIEW but who wants a portfolio that is protected against extreme price moves
4. Bear spread using puts
   - if investor has a MILDLY BEARISH VIEW about the underlying but wants a position that is not too sensitive to extreme market movements

Question 4

Put-call parity & explain the strategies

Put-call parity with dividends formula

Answer 4

C0 + PV(K) = S0 + P0
C0 + K/(1+rrf)^T = S0 + P0

1. Buy stock today and buy put
2. Buy call and invest PV(K) at risk-free rate (ie. invest in a risk-free bond)

C0 + PV(K) + PV(DIVS) = S0 + P0