Options Pricing Quiz

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Questions and Answers

What is the intrinsic value of a European Call option when the spot price is equal to the exercise price?

0 (correct)

St - PV(X)

PV(X) - St

St + PV(X)

When is a European Put option considered to be in the money?

When St = X

When St < X (correct)

When St > X

When St ~ X

Which of the following factors does NOT contribute to the time value of an option?

Time remaining until expiration

Interest rates

Intrinsic value (correct)

Volatility of the underlying asset

What happens to the intrinsic value of an out of the money European Call option?

It equals 0 Signup and view all the answers

How is the total price (premium) of an option calculated?

Option Premium = Intrinsic Value + Time Value Signup and view all the answers

Which statement is true regarding American vs. European options?

American options allow for early exercise. Signup and view all the answers

What is the absolute minimum value of any option?

0 Signup and view all the answers

What determines the minimum value of a European call option at expiration?

The maximum of 0 or the difference between the Spot Price and the present value of the exercise price Signup and view all the answers

Which statement accurately describes the maximum value of an American put option at expiration?

It is equal to the exercise price Signup and view all the answers

How does the time to expiration affect the value of options?

Shorter expiration leads to cheaper option values due to decreased uncertainty Signup and view all the answers

What is the relationship between the exercise price and the premium of a call option?

Higher exercise price results in a lower premium Signup and view all the answers

In what situation is a call option classified as 'in the money'?

When the spot price is higher than the exercise price Signup and view all the answers

What characterizes the maximum value for a European put option at expiration?

It is the maximum of 0 and the difference between the exercise price and the spot price Signup and view all the answers

Which of the following statements correctly compares the minimum value of American and European put options?

The American option can have higher minimum values due to early exercise possibility Signup and view all the answers

What indicates that you should sell a put option at a higher exercise price?

The put option will have a higher value because you can sell at a higher price Signup and view all the answers

What impact does a lower exercise price have on the premium of a call option?

It increases the premium due to a higher probability of being 'in the money'. Signup and view all the answers

How does a put option with a higher exercise price generally behave in terms of premium?

It has a higher premium because it is more likely to be 'in the money'. Signup and view all the answers

What effect does early exercise of an American option have when a dividend is approaching?

It typically reduces the option's value if exercised on the dividend date. Signup and view all the answers

In the context of interest rates, how does the value of a put option change?

It decreases with rising interest rates as immediate sale value is more appealing. Signup and view all the answers

What is the primary benefit of purchasing a call option instead of the underlying asset directly?

They allow a smaller initial investment while enabling the rest to be invested elsewhere. Signup and view all the answers

Why is the volatility of the market a significant factor in determining option premiums?

Higher volatility increases the potential for profits, raising the value of both call and put options. Signup and view all the answers

How does the presence of dividends affect the value of call options?

Call options lose value when dividends are announced as they impact intrinsic value. Signup and view all the answers

What differentiates American options from European options when considering their exercise features?

American options have the flexibility to be exercised at any time before expiration. Signup and view all the answers

What is the relationship between the exercise price and the price of a put option?

Higher exercise prices typically result in higher premiums for put options. Signup and view all the answers

Study Notes

Options Types

European Call (Ce) and Put (Pe) do not allow early exercise before expiration.
American Call (Ca) and Put (Pa) allow early exercise at any time before expiration.

Intrinsic Value of Options

European Call (Ce):
- In the money (St > X): Intrinsic Value = St - PV(X)
- At/near the money (St ~ X or St = X): Intrinsic Value = max(St - PV(X), 0)
- Out of the money (St < X): Intrinsic Value = 0
European Put (Pe):
- In the money (St < X): Intrinsic Value = PV(X) - St
- At/near the money (St ~ X or St = X): Intrinsic Value = max(PV(X) - St, 0)
- Out of the money (St > X): Intrinsic Value = 0

Time Value of Options

Represents potential for increase in value before expiration due to volatility, time, and interest rates.
Total option premium is comprised of Intrinsic Value + Time Value.
Time value is maximized for options that are at the money and decreases closer to expiration.

Option Boundaries

Minimum value of any option is 0.
Call Option:
- American Option: Minimum = max(0, St - X)
- European Option: Minimum = max(0, St - PV(X))
Put Option:
- American Option: Minimum = max(0, X - St)
- European Option: Minimum = max(0, PV(X) - St)

Maximum Values of Options

Call Option:
- Maximum = Stock Price (So).
- Maximum at expiration = max(0, So - X).
Put Option:
- Maximum = Exercise Price (X).
- Maximum at expiration = max(0, X - St).

Time to Expiration

Longer time to expiration typically leads to higher option values due to increased uncertainty.
Shorter time causes options to be cheaper due to decrease in time value.

Exercise Price Effect on Option Value

Call Options: Lower exercise prices result in higher values.
Put Options: Higher exercise prices result in higher values.

Premiums of Options

Premiums depend on exercise price, spot price, volatility, time to expiration, and interest rates.
For calls, higher exercise prices lead to lower premiums, and lower exercise prices lead to higher premiums.
For puts, higher exercise prices lead to higher premiums, and lower exercise prices lead to lower premiums.

Impact of Dividends on Options

Dividends affect the intrinsic value, with potential adjustments made to account for dividends paid before expiration.
Call option value decreases with dividends as the underlying stock may fall in value after the dividend payment.

Early Exercise

American options can be exercised early, which adds value compared to European options that cannot be exercised before expiration.
Early exercise may be beneficial for American calls before dividend dates to capture dividends.

Interest Rates

Higher interest rates generally lower put option values as immediate selling becomes more attractive.
Calls can be advantageous as they allow investing freed-up funds elsewhere.

Volatility

Higher volatility increases the value of both call and put options due to potential for larger price swings.
Historical volatility reflects past movements while implied volatility reflects market expectations.

The Greeks

Greeks measure sensitivity of option values to various factors:
- Delta: Sensitivity to spot price changes; ranges from 0 to 1.
- Gamma: Sensitivity of delta to stock price changes; highest at the money.
- Vega: Sensitivity to changes in volatility; highest value when an option is at the money.
- Rho: Sensitivity to changes in interest rates.
- Theta: Daily decrease in option value as expiration approaches.

Option Strategies

Long Put: Right to sell; hopes for So < X.
Short Call: Obligation to sell; hopes for So < X.
Long Call: Right to buy; hopes for So > X.
Short Put: Obligation to buy; hopes for So > X.
Straddle: Buying a call and a put with the same strike price.
Protective Put: Buying stock and a put to hedge.
Covered Call: Selling a call while owning the stock to generate higher income.
Strap: Buying two calls and one put for bullish sentiment.
Strip: Buying two puts and one call for bearish sentiment.

Key Examples

Call Option Example: An ANZ call with a lower exercise price ($15.50) may cost more than a higher one ($16.00) due to increased likelihood of profitability.
Put Option Example: Similar principles apply where higher exercise prices will have more value for puts.

General Strategy Insights

Profits can be made by identifying underpriced or overpriced options relative to their market value or through specific trading strategies.

These notes summarize the key concepts of options trading including valuation techniques, market behavior, and strategic approaches.

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Description

Test your understanding of options pricing with a focus on European call and put options. This quiz covers the intrinsic value calculations based on current market conditions and option types. Questions will explore scenarios such as in the money, at the money, near the money, and out of the money.

Options Pricing Quiz - Week 2

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