Black-Scholes-Merton Model Quiz

Lognormal distribution

To determine the expected return on an option

To calculate the probability of the option expiring in the money

<p>It increases the option price</p> Signup and view all the answers

<p>To describe how the value of an option changes over time</p> Signup and view all the answers

<p>They decrease the option price</p> Signup and view all the answers

<p>The key assumption is that the risk-free rate is equal to the expected return on the asset, implying that the asset's expected return is equal to the risk-free rate. This assumption is related to the capital asset pricing model, which states that the expected return on an asset is a function of its beta and the market risk premium.</p> Signup and view all the answers

<p>Futures prices on stock indices are marked-to-market, whereas forward prices are not. This means that futures prices are adjusted daily to reflect changes in the underlying index, whereas forward prices are fixed at the time of contract inception. This has implications for investors, as they must post margin to cover potential losses on futures contracts.</p> Signup and view all the answers

<p>The cost of carry refers to the storage, insurance, and other costs associated with holding a physical commodity. It affects the pricing of forward and futures contracts by increasing the forward price, as the buyer must compensate the seller for these costs.</p> Signup and view all the answers

<p>Forward prices and futures prices are equal when the risk-free rate is equal to the expected return on the asset, and there are no arbitrage opportunities. This implies that investors can earn the same return from either a forward or a futures contract, and can switch between the two without incurring additional costs.</p> Signup and view all the answers

<p>Delivery options allow the buyer to choose the delivery date, location, or quality of the underlying asset. This can affect the pricing of forward and futures contracts by increasing the flexibility of the contract, and hence the value to the buyer.</p> Signup and view all the answers

<p>Futures prices reflect the market's expected future spot price, adjusted for the cost of carry and other factors. The efficient market hypothesis suggests that futures prices are unbiased estimates of the expected future spot price, and that any deviations from this estimate are quickly arbitraged away.</p> Signup and view all the answers

<p>Real options extend the traditional capital investment appraisal framework by considering the flexibility and uncertainty associated with investment decisions, allowing for the valuation of options to expand, contract, or abandon a project. This approach recognizes that investment opportunities have inherent value beyond the initial outlay, and can be used to estimate the market price of risk.</p> Signup and view all the answers

<p>The key lessons from derivatives mishaps include the importance of understanding risk exposure, avoiding over-reliance on complex models, and maintaining adequate risk management practices. These lessons can be applied to all users of derivatives, including financial institutions and non-financial corporations, by promoting a culture of risk awareness and rigorous risk management.</p> Signup and view all the answers

<p>The CAPM is a framework for estimating the market price of risk, which represents the expected return on an investment in excess of the risk-free rate. This price of risk is a key input in the valuation of investment opportunities, and can inform decisions about the allocation of capital and the management of risk.</p> Signup and view all the answers

<p>The risk-neutral valuation framework approaches the valuation of investment opportunities by assuming that investors are risk-neutral, and that the expected return on an investment is equal to the risk-free rate. In contrast, the traditional capital investment appraisal framework approaches valuation by considering the expected cash flows and the cost of capital. The risk-neutral framework is more flexible and can handle more complex investment opportunities.</p> Signup and view all the answers

<p>The concept of real options can be used to evaluate options in an investment opportunity by recognizing the flexibility and uncertainty associated with investment decisions, and estimating the value of these options using techniques such as binomial models or simulation. The key benefits of this approach include the ability to capture the value of flexibility and uncertainty, and to make more informed investment decisions.</p> Signup and view all the answers

<p>The CAPM implies that the expected return on an investment is a function of the risk-free rate, the market return, and the beta of the investment. This model can be used to estimate the cost of capital for a business, and to inform decisions about the allocation of capital and the management of risk.</p> Signup and view all the answers