Review of Financial Options

Question 1

What is a call option?

Answer 1

The contract that has the option to buy a certain asset, to a fixed price, at a certain point in time.

Question 2

What is a put option?

Answer 2

The contract that has the option to sell a certain asset, to a fixed price, at a certain point in time.

Question 3

In an Option contract, who decides, the buyer or the seller?

Answer 3

The buyer.

Question 4

When do we exercise a call option?

Answer 4

When the price of the stock is HIGHER than the exercise/strike price.

Question 5

When do we exercise a put option?

Answer 5

When the price of the stock is LOWER than the exercise/strike price.

Question 6

What are the 2 strategies that can be used with put-call-parity relations?

Answer 6

1) We buy 1 unit of the underlying asset and then 1 unit of a put to that asset. By doing this, we earn money when the stock price is higher than the exercise price and we can cover our loss if the stock price is lower than the exercise price.
2) We buy 1 unit of a call of the underlying risk-free asset while we invest in 1 unit of the underlying risk-free asset at the same time. By doing this, we offset the loss and earn money in the stock price increases.

Question 7

How is the put-call-parity expressed?

Answer 7

S + P = C + PV(K)

Question 8

What is meant by the “No Arbitrage condition” and why is it important in the relation of calculating a synthetic call?

Answer 8

In a perfect capital market, the value of the call should then be equal to the value of its synthetic reproduction, otherwise arbitrage would be possible.

We can use this condition to calculate the value of the call.

Question 9

What is the difference between a risk-neutral world and CAPM, in terms of risk?

Answer 9

More risk does not imply a higher return. All assets are assumed to earn the same expected return, which is the risk free rate.

Question 10

What happens to the value of a CALL and a PUT if there is an increase in the stock price?

Answer 10

CALL: Will have a higher value

PUT: Will have a lower value

Question 11

What happens to the value of a CALL and a PUT if there is an decrease in the stock price?

Answer 11

CALL: Will have a lower value

PUT: Will have a higher value

Question 12

What happens to the value of a CALL and a PUT if there is an increase in maturity?

Answer 12

CALL: Will have a higher value

PUT: Will have a higher value

Question 13

What happens to the value of a CALL and a PUT if there is an increase in the stock price?

Answer 13

CALL: Will have a higher value

PUT: Will have a lower value

Question 14

What happens to the value of a CALL and a PUT if there is an increase in the interest rate?

Answer 14

CALL: Will have a higher value

PUT: Will have a lower value

Question 15

What happens to the value of a CALL and a PUT if there is an increase in the volatility? Why is this the case?

Answer 15

CALL: Will have a higher value

PUT: Will have a higher value

a larger volatility increases possible gains without affecting losses (since the value of an option is never negative)

Question 16

What is mean by the term “Moneyness”?

Answer 16

• Moneyness - Is the ratio between the S and the PV(K) - higher S –> Higher moneyness ratio –> Higher premium of the call.
• Higher K – > Lower moneyness –> Lower moneyness
• Interesting ratio to analyse when dealing with bonds because it will have an impact on the premium