Chapter 15 HW

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Chapter 15 HW 1. What are the two types of options? 1. Call options - Gives the owner the right, but not the obligation to purchase the underlying security at a predetermined price over a specified period of time.2. Put options - Gives the owner the right, but not the obligation to sell the underlying security at a predetermined price over a specified period of time. 2. Why do investors purchase or sell options? Investors purchase or sell options because they offer a cost-efficient way to speculate on price movements of underlying assets, help to hedge or reduce risk exposure of other investments or portfolios, can be used to reduce transaction costs, and can be used to reduce or delay tax exposure of an underlying asset. 3. What is the difference between an American option and a European option? The difference between American and European options is when they are exercised. American options can be exercised anytime up until the point of expiration. European options can only be exercised at expiration. The added flexibility of the American option means that it will be priced equal to, or possibly higher than, an otherwise identical European option. Most options traded in the markets are American options. However, European options are somewhat easier to analyze and are available from financial services firms. 4. What does the term “at-the-money” mean? An option is at-the-money when its exercise price equals the market price for the underlying security for both calls and puts. Note that this term is not referring to the buyer or seller, but rather to the option contract. 5. What does the term “in-the-money” mean? A call option is in-the-money when its exercise price is below the market price for the underlying security. A put option that is in-the-money has an exercise price that is above the market price for the underlying security. Note that this term is not referring to the buyer or seller, but rather to the option contract. 6. What is the intrinsic value? The intrinsic value of an option is the minimum price at which an option will trade. It equals the difference between the current underlying asset price and the exercise price. The total value of the option consists of two parts: the intrinsic value plus the time value of the option. The intrinsic value can never be less than zero. The intrinsic value of a call option equals the stock price minus the strike price, but no less than zero. The intrinsic value of a put option equals the exercise price minus the stock price, but no less than zero.

7. What is an offsetting order? An offsetting order is one that an investor uses to effectively close out an option position. For the holder (buyer) of an option, an offsetting order will write (sell) the same call or put option. For the writer (seller) of an option, an offsetting order must buy the same call or put option. 8. What does the term “out-of-the-money” mean? A call option that is out-of-the-money has an exercise price that is above the market price for the underlying security. A put option that is out-of-the-money has an exercise price that is below the market price for the underlying security. Note that this term is not referring to the buyer or seller, but rather to the option contract. 9. Why are options considered a “zero-sum game?” Options are considered a "zero-sum game" because, for every gain made by the buyer (long position), there is an equal and opposite loss incurred by the seller (short position), resulting in a total sum of gains and losses equating to zero across all option contracts. 10. Why would an investor buy a call on a stock he did not own? An investor might buy a call option on a stock they do not own because they anticipate the stock's value will increase. By purchasing a call option, they gain the right (but not the obligation) to buy the stock at a predetermined price within a specified time frame. This strategy allows the investor to participate in potential upward movements of the stock without having to own the stock outright, and it involves paying a premium for the option. 11. Why would an investor sell a call on a security they own? An investor may sell a call on a security they own to generate premium income, especially when they believe the security is fully valued or overvalued and not expected to increase in price. By selling the call option, they receive the premium, and if the stock price remains steady or declines, they keep the premium as income. If the stock rises, they may be required to deliver the stock to the option buyer but still receive the exercise price and the premium for writing the option, providing a potential hedge against unfavorable price movements. 12. Why would an investor buy a put? An investor would buy a put to speculate on a downward move in the underlying price of a security. Additionally, investors may purchase puts to provide downside protection for existing long positions, serving as a form of insurance against potential losses if the value of the underlying security declines.

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13. Why would an investor sell a put on a stock they own? Investors may sell a put on a stock they own to generate income through the premium received. This strategy serves as a hedge against price declines, as the premium helps offset potential losses. If the stock price drops and the put is exercised, the investor buys more shares at a lower price, leveraging the strategy for long-term gains. Overall, selling puts on owned stocks provides a balance of income generation and risk management in a bullish market outlook. 14. What is the difference between a market order and a limit order? Market orders and limit orders are two different methods of executing trades in the financial markets. A market order is filled at the next available price in the market, ensuring a quick execution but offering no control over the exact price at which the trade is completed. On the other hand, a limit order allows traders to specify a particular price at which they want to buy or sell. However, the execution of a limit order is contingent upon the market reaching or surpassing the specified limit price. While market orders are almost always filled, limit orders may or may not be filled, depending on market conditions. Additionally, limit orders come with the flexibility of specifying a time period during which the order is valid, such as a day, a week, a month, or until the trader decides to cancel the order, known as "good 'til cancel." In summary, market orders prioritize speed of execution, while limit orders provide control over the price but may not guarantee immediate execution. 15. When was the OCC created, what does it do, and how does it do it? The Options Clearing Corporation (OCC) was founded in 1973 and serves as the world's largest equity derivatives clearing organization. The OCC is dedicated to promoting stability and financial integrity in the marketplaces it serves by emphasizing sound risk management principles. The primary function of the OCC is to ensure that the obligations of the contracts it clears are fulfilled. It acts as both the intermediary and guarantor of options contracts, functioning as the seller for options that are purchased and as the buyer for options that are sold. To guarantee the performance of option contracts, the OCC mandates sellers of options to deposit funds as a margin requirement. This margin requirement is designed to ensure that sellers have the necessary funds to fulfill their obligations under the contract, thereby enhancing market stability and financial integrity. 16. What are the four most prevalent types of options? The four most prevalent types of options are stock options, index options, foreign currency options, and futures options. Stock options are based on shares of publicly traded companies, while index options derive their value from market indices like the S&P 500. Foreign currency options allow traders to capitalize on currency price changes or hedge currency risk, and futures options use futures contracts as their underlying securities, enabling traders to enter specific futures contracts. These options are standardized and traded on exchanges, providing various avenues for investors to manage risk, gain exposure to markets, or generate income. Additionally, there are over-the- counter (OTC) options, which are customized contracts with more complexity than standard exchange-traded options.

17. What are the basic eight options strategies? The eight basic options strategies are diverse approaches used in options trading to achieve different objectives. Long Call involves profiting from an anticipated rise in the underlying asset's price, while Long Put seeks gains from an expected decline. Covered Call generates income by selling a call against an existing stock position, and Protective Put hedges against potential stock value decreases. Long Straddle aims to profit from significant price movement in any direction, Long Strangle pursues the same but with a wider range. Iron Condor combines short put and call spreads to generate income in a range-bound market, and Butterfly Spread capitalizes on low volatility and a narrow price range. Each strategy involves varying levels of risk and complexity, and traders employ them based on their market outlook and risk tolerance. 18. What are three examples of types of securities with embedded options? Securities with embedded options include convertible bonds, allowing bondholders to convert debt into common stock; callable bonds, granting issuers the right to redeem bonds before maturity; and convertible preferred stock, enabling investors to convert preferred shares into common shares. These embedded options provide flexibility for investors and issuers, allowing them to adapt to changing market conditions and potentially benefit from stock price movements. However, they also add complexity to valuation and risk assessment, as the value of these options is influenced by various factors, including market dynamics and interest rates. 19. What does the put-call parity model do? Put-call parity is a financial principle that describes the relationship between the prices of European-style call and put options of the same class, with the same strike price and expiration date. The put-call parity model helps ensure consistency in option pricing and can be used to identify arbitrage opportunities in the financial markets. 20. What does the binomial option pricing model do and how? The Binomial Option Pricing Model is a mathematical model used for pricing options by simulating the potential future price movements of the underlying asset over discrete time intervals. Unlike the Black-Scholes Model, which assumes continuous price movements, the binomial model breaks down time into a series of discrete steps. This makes it particularly useful for valuing American-style options, which can be exercised at any time before expiration. 21. What are the variables used in the Black-Scholes Model? The Black-Scholes Model is used for pricing European-style options and relies on six main variables. These include the current stock price (S), the strike price (K), time to

expiration (T), risk-free interest rate (r), and volatility (σ). The model calculates the theoretical prices of call (C) and put (P) options based on these inputs, assuming constant volatility and interest rates, as well as the absence of dividends. It provides a framework for estimating option values and is widely used in financial markets, although it has limitations, such as its applicability to European options and assumptions that may not always hold in real-world conditions.

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