LECTURE 7

Question 1

Options =

Answer 1

a contract for an underlying asset that gives the holder the right but not the obligation to buy/sell the asset at a fixed price on or before some expiration date.

Question 2

Fixed price AKA

Answer 2

exercise/strike price

Question 3

CALL option =

Answer 3

right to BUY

Question 4

PUT option =

Answer 4

right to SELL

Question 5

European option =

Answer 5

can only exercise AT MATURITY

Question 6

AMERICAN option =

Answer 6

can exercise ANY TIME BEFORE OR AT MATURITY

Question 7

LONG option position =

Answer 7

RIGHT

Option buyer/holder

Question 8

SHORT option position =

Answer 8

OBLIGATION

option seller/writer

Question 9

Option premium:

Answer 9

the buyer pays the option seller an upfront option premium to compensate the seller for the risk of loss since obligations is costly.

Question 10

When do u buy and when exercise a CALL option?

Answer 10

Buy if expect price to rise

Exercise if market price > strike price

Question 11

When do u buy and when exercise a PUT option?

Answer 11

Buy if expect price to fall

Exercise if market price < strike price

Question 12

How are stock options contracts always written?

Answer 12

On 100 shares of stock

Question 13

What price to buyers and sellers pay on exchange?

Answer 13

BUYERS pay ASK price

SELLERS receive BID price

Question 14

At the money

Answer 14

current stock price = strike price

Question 15

In the money

Answer 15

Value > 0 if exercised immediately
Call: market price > strike price
Put: market price < strike price

Question 16

Out of the money

Answer 16

Value <= 0 if exercised immediately
Call: market price < strike price
Put: market price > strike price

Question 17

2 functions of options

Answer 17

1. Hedging

2. Speculating

Question 18

Call payoff =

Answer 18

MAX (S - K, 0)

Question 19

Put payoff =

Answer 19

MAX (K - S, 0)

Question 20

How do payoffs of put/call compare for holder/seller?

Answer 20

SYMMETRIC AROUND X AXIS

Question 21

payoffs are never…

Answer 21

less than zero

Question 22

What does calculating the PROFIT from an option include?

Answer 22

Payoff - price of option and cost of borrowing

Question 23

STRADDLE =

Answer 23

LONG-CALL & LONG-PUT on same stock with same exercise date and strike price

Question 24

When do investors use a straddle?

Answer 24

If expect price to be v volatile but do not have a view on which way the stock will move.

Question 25

When is a straddle profitable

Answer 25

When strike and stock price very far apart - either way

Question 26

STRANGLE =

Answer 26

LONG-CALL & LONG-PUT on same stock with same exercise date but CALL STRIKE > PUT STRIKE

Question 27

When do investors use a strangle?

Answer 27

When they believe the stock has a better chance of moving in a certain direction but would still like to be protected in case of a negative move.

Question 28

Zero payoff from a strangle when...

Answer 28

stock price between 2 strike prices.

Question 29

BUTTERFLY SPREAD =

Answer 29

LONG 2 CALLS with DIFFERENT STRIKES & SHORT 2 CALLS with strike = average of 2 long strikes.

Question 30

When is butterfly spread profitable

Answer 30

When strike and stock price are close together - max when S= average of 2 long strike prices.

Question 31

PROTECTIVE PUT =

Answer 31

Buy underlying share + buy put option

Question 32

Value of protective put

Answer 32

If share price > strike, put worthless so value = value of share. If share price < strike, put ITM - decline in S exactly offset by rise in put value so overall value = K

Question 33

Payoff formula for protective put

Answer 33

payoff = MAX (K - S, 0) + S

Question 34

What combo is equivalent to a protective put?

Answer 34

Buy call + risk-free zero coupon bond with face value = strike price.

Question 35

Put-call parity means

Answer 35

Payoffs of 2 strategies the same so cost must be. S + P = C + PV(K) Buy share + buy put = buy call + buy bond

Question 36

What's a synthetic share?

Answer 36

S = C - P + PV(K) Can replicate the payoff of the share by: buy call, sell put, buy bond. Replicate without risk - don't need to lay out the capital.

Question 37

If he price of the put and call are equal, what does put-call parity imply?

Answer 37

``` C = P S = PV(K) ```

Question 38

Put-call parity with dividend formula

Answer 38

C = P + S - PV(K) - PV(DIV)

Question 39

Intrinsic value of call option =

Answer 39

S - K

Question 40

Intrinsic value of Put option =

Answer 40

K - S

Question 41

Lower and upper bounds on value of American call option

Answer 41

Lower bound = intrinsic value = S - K (or 0) ensures no arbitrage Upper bound = S - cannot be worth more than the underlying stock.

Question 42

5 factors determining value of call option

Answer 42

1. Increased K = decrease C 2. Increase S = increase C 3. C long > C short 4. Increased volatility = increase C 5. Increase IR = increase C

Question 43

Why does vale of call option increases with IR?

Answer 43

Ability to delay payment - not buy the underlying asset yet - is more valuable when IR higher.

Question 44

5 factors determining value of put option

Answer 44

1. Increased K = increase P 2. Increase S = decrease P 3. P long > P short 4. Increased volatility = increase P 5. Increase IR = decrease P

Question 45

Why does vale of put option decrease with IR?

Answer 45

Delaying selling the asset and getting money in return and earning interest more costly when IR higher.