32 Questions
What type of bonds have an embedded option?
All of the above
An option is at-the-money if immediate exercise would lead to a positive cash flow.
False
What is the ratio often used to measure the degree of moneyness in empirical research?
S t / K
The option premium is quoted per unit of the underlying, and to obtain the total purchase cost, we need to multiply the quoted option premium with the _______________________ and add the transaction costs.
contract size
What is the payoff from a contract?
The net cash flow generated by the contract at the maturity date
An option is in-the-money if immediate exercise would lead to a negative cash flow.
False
Match the following options with their characteristics:
In-the-money = Immediate exercise leads to a positive cash flow Out-of-the-money = Immediate exercise leads to a negative cash flow At-the-money = Immediate exercise leads to a zero cash flow
What are the two components that the premium of an option is often decomposed into?
intrinsic value and time value
What is the right granted to the owner of a plain vanilla option?
To buy or sell the underlying at the agreed price
An American style option can be exercised only on the maturity date.
False
What is the term used to describe the act of using the right by the option buyer?
exercising the option
The owner of a plain vanilla option has the right to buy or sell a fixed amount of an underlying at an agreed price, known as the _______________
strike price
Match the following terms with their definitions:
Long position = option buyer Short position = option seller Exotic options = standard European and American calls and puts Plain vanilla options = deviate in their specification
What can an option owner do on any trading day?
Retain the option, sell the option, or exercise the option
A plain vanilla option is a security that gives the owner the obligation to buy or sell the underlying.
False
On the maturity day, the option can also ______________________.
expire
How is the profit diagram of an option often calculated?
By adding the premium to the payoff profile
The time value of money is always considered when calculating the profit diagram of an option.
False
What is the condition for an option holder to break even?
The option holder breaks even when they realize a zero profit, i.e., the long regains their paid premium and the short loses their received premium.
The profit of a long call option is calculated as Profit = ________________ - premium.
fTlong
Match the following options with their characteristics:
Long Call = Pays off when the underlying price is above the strike price Short Call = Receives premium upfront Long Put = Pays off when the underlying price is below the strike price Short Put = Pays premium upfront
The profit diagram of a long call option is always positive.
False
What is the notation for the strike price of an option contract?
K
The payoff of a long call option is always positive.
False
What is the formula for the payoff of a long call option?
max(S - K, 0)
The payoff of a long put option is equal to max(__ - S, 0) at date T.
K
What is the relationship between the payoff of a short call option and a long call option?
They are opposite
The payoff of a long put option is always increasing with the spot price.
False
What is the notation for the value of the call at date T?
fT
The payoff of a short put option is equal to -max(__ - S, 0) at date T.
K
Match the following options with their payoff diagrams:
Long Call = Increasing payoff with spot price Long Put = Decreasing payoff with spot price Short Call = Decreasing payoff with spot price Short Put = Increasing payoff with spot price
The payoff of a long call option and a short put option are the same.
False
Study Notes
Options
- A plain vanilla option is a security that gives the owner the right to buy (call option) or sell (put option) a fixed amount of an underlying asset at an agreed price (strike price, exercise price) at a maturity date (expiration date) (European style) or up to the maturity date (American style).
Definition
- The act of using the right by the option buyer is referred to as exercising the option.
- On any trading day, the owner of the option can retain the option, sell the option at its concurrent market price, or exercise the option if the contract allows it.
- On the maturity day, the option can also expire.
Terminology
- Long position: option buyer (who holds the right to exercise the option)
- Short position: option seller or option writer (who holds the contingent obligation)
- Plain vanilla options: standard European and American calls and puts
- Exotic options: deviate in their specification in one way or another from vanilla options, e.g. barrier options, Asian options, lookback options, compound options
Terminology (continued)
- Embedded options: callable bonds, convertible bonds, mortgages
- Real options
Moneyness
- In-the-money: if immediate exercise would lead to a positive cash flow
- Call: if S > K
- Put: if S < K
- Out-of-the-money: if immediate exercise would lead to a negative cash flow
- At-the-money: if immediate exercise would lead to a zero cash flow
- The ratio S/K is often used to measure the degree of moneyness
The Quoted Premium
- The option premium is quoted per unit of the underlying
- To obtain the total purchase cost, the quoted premium is multiplied with the contract size, and transaction costs are added
- The premium is often decomposed into an intrinsic value (i.e. S - K) and a time value (i.e. premium - intrinsic value)
Payoff and Profit
- Payoff: the net cash flow generated by the contract at maturity date
- Payoff profiles:
- Long call: max(S - K, 0)
- Short call: -max(S - K, 0)
- Long put: max(K - S, 0)
- Short put: -max(K - S, 0)
- Profit diagrams:
- Long: payoff - premium
- Short: payoff + premium
Breaking Even
- The option holder will break even (i.e. realize a zero profit) if:
- The long regains the paid premium
- The short loses the received premium
This quiz covers the basics of options, a type of derivative, in financial markets. Learn about the definition and concepts related to options with Prof. Dr. M. De Ceuster.
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