Derivatives

Front 1

Give two reasons that the early exercise of an American call option on a non-dividend-payingstock is not optimal. The first reason should involve the time value of money. The second reasonshould apply even if interest rates are zero.

Back 1

Delaying exercise delays the payment of the strike price. This means that the option holder isable to earn interest on the strike price for a longer period of time. Delaying exercise alsoprovides insurance against the stock price falling below the strike price by the expiration date.Assume that the option holder has an amount of cash K and that interest rates are zero. Whenthe option is exercised early it is worth ST at expiration. Delaying exercise means that it will be worth max(K,ST ) at expiration.

Front 2

Principle Protected Notes

Back 2

A fixed income security that guarantees a minimum return equal to the investor's initial investment (the principle amount)

Front 3

Covered Call

Back 3

long stock+short put

Front 4

Reverse of Covered Call

Back 4

short stock+long put

Front 5

Protective Put

Back 5

Buying both a put and the option itself

Front 6

Reverse of Protective Put

Back 6

short put+short the stock

Front 7

Spread

Back 7

Trading strategy that involves taking a position in two or more of the same option types (i.e. 2 or more calls or 2 or more puts)

Front 8

Bull Spread

Back 8

Buying call w/ a lower K, sell call w/ higher k

(anticipating modest increase)

can also be made w/ puts buy put w/ low k, sell put w/ high k

Front 9

Bear Spread

Back 9

Buy put w/ high K, sell put w/ low k (investor anticipating decrease)

Front 10

Box Spread

Back 10

a bull and bear spread with identical expiry dates. This investment strategy provides for minimal risk. Additionally, it can lead to an arbitrage position as an investor attempts to lock in a small return at expiry.

Front 11

Butterfly Spread

Back 11

1 option w/ low K (buy)

2 options w/ middle K (sell)

1 option w/ high K (buy)

Front 12

Calander Spread

Back 12

sell call w/ certain k & buy call w/ same k but longer maturity

Investor makes profit if St at exp. of shorters option is close to K but a loss if St is significantly above or below

Front 13

Combinations

Back 13

Option trading strategy that involves taking a position in both calls & puts on same stock (straddle, strangle, strips)

Front 14

Straddle

Back 14

Buy both call & put w/ same K & exp.

Profit is made w/ significant movement

Loss if St is close to K @ exp.

Front 15

Strip

Back 15

Buy Call & sell 2 puts w/ same K

Investor expects large move, most likely down

Front 16

Strap

Back 16

Buy 2 calls & a put

Investor expecting large move, most likely up

Front 17

Strangles

Back 17

Investor buys put & call w/ exp. but different k

investor is predicting large move but unsure whether up or down

Front 18

a) Limit Move

b) Limit down

c) Limit Up

Back 18

a) a move in either direction of daily limit

b) move up to limit

c) move down to limit

Front 19

Convergence of Future & Spot Prices

Back 19

-As delivery for futures contracts is approach, the futures price converges to the spot price of the underlying asset

-There would be an arbitrage opportunity if not

Front 20

Clearing House

Back 20

Acts as intermediary in futures transactions. It guarantees the performance of the parties for each transactions

Front 21

Market Order

Back 21

Request that the trade carried out immediately

Front 22

Limit Orders

Back 22

Specifies a specific price order is only executed at this price or one more favorable

Front 23

Stop Order or Stop Loss

Back 23

Also specifies a price, order is executed at the best available price or a less-favorable price. Stop-loss order becomes a market order as soon as specified price has been hit. Purpose of a stop order is usually to close out a postion if unfavorable price movements take place, it limits the loss that can be incurred.

Front 24

Stop-Limit Order

Back 24

Combo of a stop order & a limit order. Order becomes limit order as soon as a bid or offer is made at a price equal to or less favorable than the stop price. Two prices must be specified

Front 25

Market-if-Touched Order

Back 25

Order is executed at the best available price or at a price more favorable than the specified price. MIT order designed to ensure profits are taken if sufficiently favorable price movements occur.

Front 26

Discretionary (or market no held) Order

Back 26

Traded as a market order but execution may be delayed at broker's discretion

Front 27

Fill-or-Kill

Back 27

Execute immediately or not at all

Front 28

It is sometimes argued that a forward exchange rate is an unbiased predictor of future exchangerates. Under what circumstances is this so?

Back 28

the forward exchange rate is an unbiasedpredictor of the future exchange rate when the exchange rate has no systematic risk. To have nosystematic risk the exchange rate must be uncorrelated with the return on the market.

Front 29

Give two reasons that the early exercise of an American call option on a non-dividend-payingstock is not optimal. The first reason should involve the time value of money. The second reasonshould apply even if interest rates are zero

Back 29

Delaying exercise delays the payment of the strike price. This means that the option holder isable to earn interest on the strike price for a longer period of time. Delaying exercise alsoprovides insurance against the stock price falling below the strike price by the expiration date.Assume that the option holder has an amount of cash K and that interest rates are zero. Whenthe option is exercised early it is worth ST at expiration. Delaying exercise means that it will be worth max(K,ST ) at expiration.

Front 30

Explain the no-arbitrage and risk-neutral valuation approaches to valuing a European optionusing a one-step binomial tree.

Back 30

In the no-arbitrage approach, we set up a riskless portfolio consisting of a position in the optionand a position in the stock. By setting the return on the portfolio equal to the risk-free interestrate, we are able to value the option. When we use risk-neutral valuation, we first chooseprobabilities for the branches of the tree so that the expected return on the stock equals the risk-free interest rate. We then value the option by calculating its expected payoff and discountingthis expected payoff at the risk-free interest rate.

Front 31

What is meant by the delta of a stock option?

Back 31

The delta of a stock option measures the sensitivity of the option price to the price of the stock when small changes are considered. Specifically, it is the ratio of the change in the price of thestock option to the change in the price of the underlying stock.

Front 32

What does the Black–Scholes–Merton stock option pricing model assume about the probabilitydistribution of the stock price in one year? What does it assume about the probabilitydistribution of the continuously compounded rate of return on the stock during the year?

Back 32

The Black–Scholes–Merton option pricing model assumes that the probability distribution of thestock price in 1 year (or at any other future time) is lognormal. It assumes that the continuouslycompounded rate of return on the stock during the year is normally distributed.

Front 33

Distinguish between the terms open interest and trading volume.

Back 33

The open interest of a futures contract at a particular time is the total number of long positionsoutstanding. (Equivalently, it is the total number of short positions outstanding.) The tradingvolume during a certain period of time is the number of contracts traded during this period.