3.5 Option_a non-dividend paying stock is currently trading a-CSDN博客

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3.5 Option

Question 1

A non-dividend-paying stock is currently trading at USD $40$ and has an expected return of $12\%$ per year. Using the Black-Scholes-Merton (BSM) model, a 1-year, European-style call option on the stock is valued at USD $1.78$ . The parameters used in the model are: $N(d_1) = 0.29123$ , $N(d_2) = 0.20333$

The next day, the company announces that it will pay a dividend of USD $0.5$ per share to holders of the stock on an ex-dividend date $1$ month from now and has no further dividend payout plans for at least $1$ year. This new information does not affect the current stock price, but the BSM model inputs change, so that: $N(d_1) = 0.29928$ , $N(d_2) = 0.20333$

If the risk-free rate is $3\%$ per year, what is the new BSM call price?

A. USD $1.61$
B. USD $1.78$
C. USD $1.95$
D. USD $2.11$

Answer: C
The value of a European call is equal to $S\times N(d_1) - Ke^{-rT}\times N(d_2)$ , where $S$ is the current price of the stock. In the case that dividends are introduced, $S$ in the formula is reduced by the present value of the dividends.

Furthermore, the announcement would affect the values of $S$ , $d_1$ , and $d_2$ . However, since we are given the new values, and $d_2$ is the same, the change in the price of the call is only dependent on the term $S\times N(d_1)$ .

Previous: $S\times N(d_1)= 40\times0.29123 = 11.6492$
New: $S\times N(d_1) = (40 - 0.5\times e^{-3\%/12})\times0.29928 = 11.8219$
Change: $11.8219 - 11.6492 = 0.1727$

So the new BSM call price would increase in value by $0.1727$ , which when added to the previous price of $1.78$ equals $1.9527$ .

Question 2

PE2018Q82 / PE2019Q82 / PE2020Q82 / PE2021Q82 / PE2022Q82
The current stock price of a share is USD $100$ , and the continuously compounding risk-free rate is $12\%$ per year. If the strike price for all options is USD $90$ , what are the maximum possible prices for a 3-month European call option, American call option, European put option, and American put option?

A. $97.04$ , $97.04$ , $87.34$ , $87.34$
B. $97.04$ , $100$ , $90$ , $90$
C. $100$ , $100$ , $87.34$ , $90$
D. $100$ , $100$ , $90$ , $90$

Answer: C
Learning Objective: Identify and compute upper and lower bounds for option prices on non- dividend and dividend paying stocks.

European call option, minimum value: $c\geq\text{max}(S_0-Ke^{-rT},0)$ , maximum value: $S_0$

American call option, minimum value: $c\geq\text{max}(S_0-Ke^{-rT},0)$ , maximum value: $S_0$

European put option, minimum value: $p\geq\text{max}(Ke^{-rT}-S_0,0)$ , maximum value: $Ke^{-rT}$

American put option, minimum value: $p\geq\text{max}(K-S_0,0)$ , maximum value: $K$

Question 3

Jeff is an arbitrage trader, and he wants to calculate the implied dividend yield on a stock while looking at the over-the-counter price of a 5-year put and call (both European-style) on that same stock. He has the following data:

• Initial stock price: USD $85$
• Strike price: USD $90$
• Continuous risk-free rate: $5\%$
• Underlying stock volatility: unknown
• Call price: USD $10$
• Put price: USD $15$

What is the continuous implied dividend yield of that stock?

A. $2.48\%$
B. $4.69\%$
C. $5.34\%$
D. $7.71\%$

Answer: C
Put-Call Parity
For European option: $C+Xe^{-rT}=S+P$
For American option: $S_0-X\leq C-P\leq S_0-Xe^{-rT}$

Put-Call Parity within dividend
For European option: $C+Xe^{-rT}+D=S+P$
For American option: $S_0-X-D\leq C-P\leq S_0-Xe^{-rT}$

Question 4

Stock UGT is trading at USD $100$ . A 1-year European call option on UGT with a strike price of USD $80$ is trading at USD $30$ . No dividends are being paid in the following year. What should be the lower bound for an American put option on UGT with a strike price of USD $80$ , in order to not have arbitrage opportunities? Assume a continuously-compounded risk-free rate of $4\%$ per year.

A. $6.1$
B. $7.7$
C. $5.7$
D. $6.9$

Answer: D
The European call option is the same as an American call option, since there are no dividends during the life of the options. American call and put prices satisfy the inequality.

$S-K\leq C-P\leq S- Ke^{-rT}$ , thus $Ke^{-rT}-S+C \leq P\leq K-S+C$ , therefore: $6.86\leq P \leq 10$ .

Question 5

PE2018Q56
A trader writes the following 1-year European-style barrier options as protection against large movements in a non-dividend paying stock that is currently trading at EUR $42.80$ .

Option	Price (EUR)
Down-and-in barrier put, with barrier at EUR 36	2.20
Down-and-out barrier put, with barrier at EUR 36	1.50
Up-and-in barrier call, with barrier at EUR 46	3.20
Up-and-out barrier call, with barrier at EUR 46	1.70

All of the options have the same strike price. Assuming the risk-free rate is $1.8\%$ per annum, what is the common strike price of these options?

A. EUR $39.00$
B. EUR $40.62$
C. EUR $41.20$
D. EUR $42.36$

Answer: D
Learning Objective: Identify and describe the characteristics and pay-off structure of the following exotic options: gap, forward start, compound, chooser, barrier, binary, lookback, shout, Asian, exchange, rainbow, and basket options.

The sum of the price of an up-and-in barrier call and an up-and-out barrier call is the price of an otherwise equivalent European call. The price of the European call is $3.20 + 1.70 = 4.90$ .

The sum of the price of a down-and-in barrier put and a down-and-out barrier put is the price of an otherwise equivalent European put. The price of the European put is $2.20 + 1.50 = 3.70$ .

Using put-call parity, where $C$ represents the price of a call option and $P$ the price of a put option,

$C+Ke^{-rt}=P+S \to K=e^{rt}(P+S-C)$

Hence, $e^{0.018\times 1}\times (3.70+ 42.80 - 4.90) = 42.36$

Question 6

PE2018Q3 / PE2019Q3 / PE2020P3 / PE2021Q3 / PE2022Q3 / PE2022PSQ18
The price of a six-month, USD $25$ strike price, European put option on a stock is USD $3$ . The stock price is USD $26$ . A dividend of USD $1$ is expected in three months. The continuously compounded risk-free rate for all maturities is $5\%$ per year. Which of the following is closest to the value of a European call option on the same underlying stock with a strike price of USD $25$ and a time to maturity of six months?

A. USD $1.63$
B. USD $2.40$
C. USD $3.63$
D. USD $4.62$

Answer: C
Learning Objective: Explain put-call parity and apply it to the valuation of European and American stock options with dividends and without dividends, and express it in terms of forward prices.

From the equation for put-call parity, this can be solved by the following equation:

$c = S_0 + p - PV(K) - PV(D)$

where $P V$ represents the present value, so that

$\times e^{-rT}$ and $\times e^{-rt}$

Where:
$p$ is the put price,
$c$ is the call price,
$K$ is the strike price of the put option,
$D$ is the dividend,
$S_0$ is the current stock price.
$T$ is the time to maturity of the option,
$t$ is the time to the next dividend distribution.

Question 7

PE2018Q61 / PE2019Q61 / PE2020Q61 / PE2021Q61 / PE2022Q61
Consider an American call option and an American put option, each with $3$ months to maturity, written on a non-dividend-paying stock currently priced at USD $40$ . The strike price for both options is USD $35$ and the risk-free rate is $1.5\%$ . What are the lower and upper bounds on the difference between the prices of the call and put options?

Scenario	Lower Bound	Upper Bound
A	$0.13$	$34.87$
B	$5.00$	$5.13$
C	$5.13$	$40.00$
D	$34.87$	$40.00$

A. Scenario A
B. Scenario B
C. Scenario C
D. Scenario D

Answer: B
Learning Objective:

Identify and compute upper and lower bounds for option prices on non-dividend and dividend paying stocks.
Explain put-call parity and apply it to the valuation of European and American stock options, with dividends and without dividends, and express it in terms of forward prices.

The put-call parity in case of American options leads to the inequality:

$S_0-K\leq C - P\leq S_0-Ke^{-rT}\to5\leq C-P\leq5.13$

Alternatively, the upper and lower bounds for American options are given by

Option	Minimum Value	Maximum Value
American Call	$C\geq \text{Max}(0,S_0-Xe^{-rT})=5.13$	$S_0=40$
American Put	$P\geq \text{Max}(0,X-S_0)=0$	$X = 35$

Subtracting the put values from the call values in the table above, we get the same result $\leq C-P\leq 5.13$

Question 8

A risk manager is analyzing the option prices for a non-dividend-paying stock. How would the risk manager create a synthetic long European call option position on this stock using an appropriate zero-coupon risk-free bond and options having the same exercise price and exercise date?

A. Buy a European put on the stock, buy the stock, and sell a zero-coupon risk-free bond.
B. Buy a European put on the stock, sell the stock, and buy a zero-coupon risk-free bond.
C. Sell a European put on the stock, buy the stock, and sell a zero-coupon risk-free bond.
D. Sell a European put on the stock, sell the stock, and buy a zero-coupon risk-free bond.

Answer: A
The put-call parity can be rearranged to create synthetic equivalencies.

Synthetic call: $c = S+p - Xe^{-rT}$
Synthetic put: $p = c + Xe^{-rT}-S$
Synthetic stock: $S = c +Xe^{-rT}-p$
Synthetic bond: $Xe^{-rT} = S+p -c$

Note: the term $+$ means long and $-$ means short.

Question 9

PE2018Q89 / PE2019Q89 / PE2020Q89 / PE2021Q89
Which of the following statements is correct about the early exercise of American options?

A. It is always optimal to exercise an American call option on a non-dividend-paying stock before the expiration date.
B. It can be optimal to exercise an American put option on a non-dividend-paying stock early.
C. It can be optimal to exercise an American call option on a non-dividend-paying stock early.
D. It is never optimal to exercise an American put option on a non-dividend-paying stock before the expiration date.

Answer: B
Learning Objective: Explain how dividends affect the decision to exercise early for American call and put options.

It is never optimal to exercise an American call option on a non-dividend-paying stock before the expiration date, but at any given time during its life, a put option should always be exercised early if it is sufficiently deep in the money. Thus, it can be optimal to exercise an American put-option on a non-dividend-paying stock early.

Question 10

Consider the following bearish option strategy of buying one at-the-money put with a strike price of $ $43$ for $ $6$ , selling two puts with a strike price of $ $37$ for $ $4$ each and buying one put with a strike price of $ $32$ for $ $1$ . If the stock price plummets to $ $19$ at expiration, calculate the net profit/loss per share of the strategy.

A. $- 2.00$ per share
B. Zero no profit or loss
C. $1.00$ per share
D. $2.00$ per share

Answer: D
The easiest thing to do is to find the net profit or loss for each position and then add them together, recognizing whether a position is short or long.

For $1$ long $ $43$ strike put position: $43 - 19 - 6 = 18$
For $2$ short $ $37$ strike puts position: $\times (37 -19- 4)= 28$
For $1$ long $ $32$ strike put position: $32 - 19 - 1 = 12$

The sum of these profit/loss numbers is a $ $2$ gain.

Question 11

An investor owns a stock and is bullish over the short term. Which of the following strategies will be the most appropriate one for this investor if the primary concern is to make a bet on the volatility of the stock?

A. A covered call
B. A protective put
C. An at-the-money strip
D. An at-the-money strap

Answer: D
Straddle

long straddle = long call + long put, this strategy is profitable when the stock price moves strongly in either direction, and this strategy bets on volatility.
short straddle = short call + short put, this strategy bets on little movement in the stock.
call and put option have same strike price.

Strangle

long strangle = long call option at $K_1$ and long put option at $K_2$
Compared with straddle, strangle strategy has different strike price, $K_1>K_2$
It is more cheaper.

Strips

long strips = long 2 put + long 1 call, call and put option have same strike price
This strategy is profitable when the stock price moves strongly downwards

Straps

long straps = long 2 call + long 1 put, call and put option have same strike price
This strategy is profitable when the stock price moves strongly upwards

Question 12

Which option combination most closely simulates the economics of a short position in a futures contract?

A. Payoff of a long call plus a short put
B. Profit of a long call plus a short put
C. Payoff of a long put plus short call
D. Profit of long put plus short call

Answer: C
Payoff of the long put equals to $\text{Max}[0, K - S(t)]$ and payoff of short call equals to $-\text{Max}[0, S(t) - K] = \text{Min}[K - S(t))$ , such that the combination payoff equals to $K - S (t)$ .

In regard to D, please note: Profit = the payoff - initial investment [net premium], sometime also profit = payoff - FV (initial investment)

Question 13

A butterfly spread involves positions in options with three difference strike prices. It can be created by buying a call option with a low strike of $X_1$ ; buying a call option with a high strike $X_3$ ; and selling two call options with a strike $X_2$ halfway between $X_1$ and $X_3$ . What can be said about the upside and downside of the strategy?

A. Both the upside and downside is unlimited.
B. Both the upside and downside is limited.
C. The upside is unlimited but the downside is limited.
D. The upside is limited but the downside is unlimited.

Answer: B
The pay-off structure to this strategy leaves the upside and downside potential at the difference between the premium collected on the calls sold and the premium paid on the calls purchased.

Butterfly spread with call options

Long 1 call at $X_1$ +short 2 call at $X_2$ +long 1 call at $X_3$
$X_1<X_2<X_3$ , usually $X_2=(X_1+X_3)/2$

Butterfly spread with put options
Long 1 put at $X_1$ +short 2 put at $X_2$ +long 1 put at $X_3$
$X_1<X_2<X_3$ , usually $X_2=(X_1+X_3)/2$

Question 13
The payoff on a calendar spread is most similar to which of the following option strategies?

A. Bull spread
B. Bear spread
C. Long straddle
D. Butterfly spread

Answer: D
A calendar spread is created by transacting in two options that have different expirations. Both options have the same strike price. The strategy sells the short-dated option and buys the long-dated option.
The investor profits only if the stock remains in a narrow range, but losses are limited. Overall, the payoff is most similar to the butterfly spread.
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Question 14

PE2018Q7 / PE2019Q7 / PE2020Q7 / PE2021Q7 / PE2020Q7
An investor sells a January 2019 call on the stock of XYZ Limited with a strike price of USD $50$ for USD $10$ , and buys a January 2019 calll on the same underlying stock with a strike price of USD $60$ for USD $2$ . What is the name of this strategy, and what is the maximum profit and loss the investor could incur at expiration?

	Strategy	Maximum Profit	Maximum Loss
A	Bear spread	USD $8$	USD $2$
B	Bull spread	USD $8$	Unlimited
C	Bear spread	Unlimited	USD $2$
D	Bull spread	USD $8$	USD $2$

Answer: A
Learning Objective: Identify and compute upper and lower bounds for option prices on non-dividend and dividend paying stocks.

This strategy of buying a call option at a higher strike price and selling a call option at lower strike price with the same maturity is known as a bear spread. To establish a bull spread, one would buy a call option at a lower price and sell a call option on the same security with the same maturity at a higher strike price.

The cost of the strategy will be: $- 10 + 2 = - 8$ (a negative cost, which represents an inflow of USD $8$ to the investor)

The maximum payoff occurs when the stock price $S_T ≤ 50$ and is equal to USD $8$ (the cash inflow from establishing the position) as none of the options will be exercised. The maximum loss occurs when the stock price $S_T ≥ 60$ at expiration, as both options will be exercised. The investor would then be forced to sell XYZ shares at USD $50$ to meet the obligations on the call option sold, but could exercise the second call to buy the shares back at USD $60$ for a loss of USD $- 10$ . However, since the investor received an inflow of USD $8$ by establishing the strategy, the total profit would be USD $8 - 10 = - 2$ .

When the stock price is $50 < S_T ≤ 60$ , only the call option sold by the investor would be exercised, hence the payoff will be $50 - S_T$ . Since the inflow from establishing the original strategy was USD $8$ , the net profit will be $58 - S_T$ , which would always be higher than USD $- 2$ .

Question 15

Options have just started trading for a non-dividend-paying stock. The stock is trading at USD $50$ . The risk-free rate is $1.5\%$ per year. The prices of some 1-year European options on the stock are displayed in the table below. What arbitrage opportunity exists given these prices?

Option	Strike (USD)	Price (USD)
Call	40	11
Call	50	8.75
Call	60	5

A. Sell two calls with strike USD $40$ ; buy one call with strike USD $50$ ; sell one call with strike USD $60$
B. Buy one call with strike USD $40$ ; sell two calls with strike USD $50$ ; buy one call with strike USD $60$
C. Sell two calls with strike USD $40$ ; buy one call with strike USD $50$ ; buy one call with strike USD $60$
D. Buy one call with strike USD $40$ ; sell two calls with strike USD 50; sell one call with strike USD $60$

Question 16

A cash-or-nothing call (also known as a digital call) pays a fixed amount to the buyer if the asset finishes above the strike price. Assume that at the end of a 1-year investment horizon, the stock is equal to $ $50$ , the fixed payment amount is equal to $ $45$ , and $N(d_1)$ and $N(d_2)$ from the Black-Scholes-Merton model are equal to $0.9767$ and $0.9732$ , respectively. The value of this cash-or-nothing call when the risk-free rate equals $3\%$ is closest to:

A. $ $5$
B. $ $42$
C. $ $44$
D. $ $47$

Answer: B
Since the Black-Scholes-Merton formula denotes $N(d_2)$ as the probability of the asset price being above tte strike price, the value of a cash-or-nothing call is equal to: $K\times N(d_2)e^{-rt}= 45\times e^{-0.03}\times 0.9732 = 42.50$

Question 17

A 1-year forward contract on a stock with a forward price of USD $100$ is available for USD $1.50$ . The table below lists the prices of some barrier options on the same stock with a maturity of 1 year and strike of USD $100$ . Assuming a continuously compounded risk-free rate of $5\%$ per year what is the price of a European put option on the stock with a strike of USD $100$ .

Option	Price
Up-and-in barrier call, barrier USD 95	USD 5.21
Up-and-out barrier call, barrier USD 95	USD 1.40
Down-and-in barrier put, barrier USD 80	USD 3.5

A. USD $2.00$
B. USD $4.90$
C. USD $5.11$
D. USD $6.61$

Answer: C
The sum of the price of up-and-in barrier call and up-and-out barrier call is the price of an otherwise the same European call. The price of the European call is therefore $5.21 + 1.40 = 6.61$ .

The put-call parity relation gives Call - put = Forward (with same strikes and maturities). Thus $\text{put} = 1.50 \to \text{put} = 5.11$

Options that cease to exist when a barrier is reached are knock-out options, and options that come into existence when a barrier is reached are knock-in options.

There are four types of barrier options. (Call & Put for each)

Down-and-out: European option that ceases to exist if the asset price moves down to the barrier level.
Down-and-in: European option that comes into existence if the asset price moves down to the barrier level.
Up-and-out: European option that ceases to exist if the asset price moves up to the barrier level.
Up-and-in: European option that comes into existence if the asset price moves up to the barrier level.

Barrier options are less expensive than regular options.

Down-and-out call (put) plus a down-and-in call (put) equals to a regular call (put) option.

For knock-out options, an increase in the volatility may lower the price. For knock-in options, an decrease in the volatility may lower the price.

Vega of barrier options can be negative.

Question 18

You are an institutional portfolio manager. One of your clients is very interested in the flexibility of options but expresses great concern about the high cost of some of them. In general, which of the following options would be the least costly to purchase?

A. Chooser options
B. American options
C. Lookback options
D. Bermudan options

Answer: D
Chooser Options: It has the feature that the holder can choose whether the option is a call or a put after a specified period time.

Lookback Options: It provide a payoff depends on the maximum or minimum asset price reached during the life of the option.
There are four types of lookback options:

A fixed(strike) lookback call option payoff: $\text{Max}(S_{\text{MAX}}-K, 0)$
A fixed(strike) lookback put option payoff: $\text{Max}(K - S_{\text{min}},0)$
A floating(strike) lookback call option payoff: $\text{Max}(S_T - S_{\text{min}}, 0)$
A floating(strike) lookback put option payoff: $\text{Max}(S_{\text{max}}- S_T, 0)$

Bermudan options may be exercised early (like American options) but exercise is restricted to certain dates. Therefore, the restriction suggests that Bermudan options must be cheaper than American options.

Question 19

Looking at a risk report. Mr. Woo finds that the options book of Ms.Yu has only long positions and yet has a negative delta. He asks you to explain how that is possible. What is a possible explanation?

A. The book has a long position in up-and-in call options.
B. The book has a long position in binary options.
C. The book has a long position in up-and-out call options.
D. The book has a long position in down-and-out call options.

Answer: C
As the underlying assets’ price increases the up-and-out call options become more vulnerable since they will cease to exist when the barrier is reached. Hence their price decreases. This is negative delta.

Question 20

Of the following options, which one does not benefit from an increase in the stock price when the current stock price is $ $100$ and the barrier has not yet been crossed:

A. A down-and-out call with out barrier at $ $90$ and strike at $ $110$
B. A down-and-in call with in barrier at $ $90$ and strike at $ $110$
C. An up-and-in put with barrier at $ $110$ and strike at $ $100$
D. An up-and-in call with barrier at $ $110$ and strike at $ $100$

Answer: B
A down-and-out call where the barrier has not been touched is still alive and hence benefits from an increase in $S$ , so A is incorrect.

A down-and-in call only comes alive when the barrier is touched, so an increase in $S$ brings it away from the barrier. This is not favorable, so B is correct.

An up-and-in put would benefit from an increase in $S$ as this brings it closer to the barrier of $ $110$ , so C is not correct.

An up-and-in call would also benefit if $S$ gets closer to the barrier.

Question 21

Vega is the sensitivity of an option’s price to changes in volatility. Increases in an underlying instrument’s volatility will usual increase the value of options since increases in volatility produce a greater probability that an option will find its way into the money. Of the four options listed below, which investment has the potential to produce a negative Vega measure?

A. Chooser option
B. Call option
C. Put option
D. Barrier option

Answer: D
Increased volatility on down-and-out and up-and-out barrier options does not increase value because the closer the underlying instrument gets to the barrier price, the greater the chance the option will expire. Therefore, Vega may be negative for a barrier option.

Question 22

Assume a European chooser option where stock price is $ $10$ , strike price is $ $10$ , volatility is $20\%$ , dividend yield is $0\%$ , and risk-free rate is $4\%$ . The choice can be made within the next six months ( $T_1 = 0.5$ year) and the option will expire in one year ( $T_2 = 1.0$ year). What is a synthetic (portfolio) equivalent to the chooser option?

A. A call option with strike price $10$ and maturity 1 year and a put option with strike price $9.80$ and maturity $0.5$ year.
B. A call option with strike price $10$ and maturity $0.5$ year and a put option with strike price $9.80$ and maturity $1$ year.
C. A put option with strike price $10$ and maturity $1$ year and a put option with strike price $9.80$ and maturity $0.5$ year.
D. A put option with strike price $10$ and maturity $0.5$ year and a call option with strike price $9.80$ and maturity $1$ year.

Answer: A
$\text{Max}(c, p) = \text{Max}[c,c+ Ke^{-r(T_2-T_1)} -S_1] =C+\text{Max}[0, Ke^{-r(T_2-T_1)} -S_1]$
$\text{Max}(c, p)=\text{Max}[p, p+S-Ke^{-r(T_2-T_1)} ] = p + \text{Max}[0, S_1-Ke^{-r(T_2-T_1)}]$

Question 23

A stock is currently trading at USD $45$ , and its annual price volatility is $30\%$ . The risk-tree rate is $1.5\%$ per year. A risk manager is developing a 1-step binomial tree for a 2-year horizon. What is the risk-neutral probability that the stock will move down?

A. $30\%$
B. $43\%$
C. $57\%$
D. $70\%$

Answer: C
$Se^{r\Delta t}=pSu+(1-p)Sd \to p=\frac{e^{r\Delta t}-u}{u-d}$
where $u=e^{\sigma\sqrt{\Delta t}}$ , $d=e^{-\sigma\sqrt{\Delta t}}$

Question 24

A trader holds a 1-year American put option with a strike price of USD $100$ on a stock currently trading at USD $85$ . To value the option, a one-stop binomial tree is used where the stock price can move up or down by USD $10$ in the 1-year period. If the risk-neutral probability of the stock moving up is $81\%$ and the risk free rate is $6\%$ per year. What is the current value of the American put?

A. USD $8.29$
B. USD $15.00$
C. USD $17.01$
D. USD $19.97$

Answer: B

American put does not early exercise: $P_0=\cfrac{5\times81\%+25\times19\%}{e^{6\%\times1}}=8.29$

American put early exercise: $P_0=K-S=15$

Question 25

An analyst is pricing a 2-year European put option on a non-dividend-paying stock using a binomial tree with two time steps of one year each. The stock price is currently USD $38$ , and the strike price of the put is USD $40$ . What is the value of the put closest to, assuming that the annual risk-free rate will remain constant at $2\%$ over the next two years and the annual stock volatility is $15\%$

A. USD $3.04$
B. USD $3.48$
C. USD $3.62$
D. USD $3.81$

Answer: B

$u=e^{\sigma\sqrt{\Delta t}}=1.16$ , $d=\cfrac{1}{u}=0.86$
$p=\cfrac{e^{r\Delta t}-u}{u-d}=0.53$

$\text{Node 2}=(0\times53\%+2.09\times47\%)e^{2\%}=1.00$

$\text{Node 3}=(2.09\times53\%+11.90\times47\%)e^{2\%}=6.84$

$\text{Node 3}=(1.00\times53\%+6.84\times47\%)e^{2\%}=3.48$

Question 26

PE2018Q87 / PE2019Q87 / PE2020Q87 / PE2021Q87
A risk manager for Bank XYZ, Mark is considering writing a $6$ month American put option on a non-dividend paying stock ABC. The current stock price is USD $50$ and the strike price of the option is USD $52$ . In order to find the no-arbitrage price of the option Mark uses a two-step binomial tree model. The stock price can go up or down by $20\%$ each period. Mark’s view is that the stock price has an $80\%$ probability of going up each period and a $20\%$ probability of going down. The annual risk-free rate is $12\%$ with continuous compounding.

What is the risk-neutral probability of the stock price going up in a single step?

A. $34.5\%$
B. $57.6\%$
C. $65.5\%$
D. $80.0\%$

Answer: B
Learning Objective: Calculate the value of an American and a European call or put option using a one-step and two-step binomial model.

$P_{\text{up}}=\cfrac{e^{r\Delta t}-d}{u-d}=\cfrac{e^{0.12\times3/12}-0.8}{1.2-0.8}=57.61\%$

$P_{\text{down}}=1-P_{\text{up}}=42.39\%$

Question 27

PE2018Q88 / PE2019Q88 / PE2020Q88 / PE2021Q88
Common text from question 26, the no-arbitrage price of the option is closest to:

A. USD $2.00$
B. USD $2.93$
C. USD $5.22$
D. USD $5.86$

Answer: D
Learning Objective: Calculate the value of an American and a European call or put option using a one-step and two-step binomial model.

The figure shows the stock price and the respective option value at each node, At the final nodes, the value is calculated as $\text{Max}(0,K-S)$

Node 2: $(57.61\%\times0+43.39\%\times4)e^{-12\%\times3/12}=1.65$ , which is greater than the intrinsic value of the option at this node equal to $\text{Max}(0, 52-60)=0$ , so the option should not be exercised early at this node.

Node 3: $(57.61\%\times4+43.39\%\times20)e^{-12\%\times3/12}=10.46$ , which is lower than the intrinsic value of the option at this node equal to $\text{Max}(0, 52-40)=12$ , so the option should be exercised early at this node.

Node 1: $(57.61\%\times1.65+43.39\%\times12)e^{-12\%\times3/12}=5.86$ , which is greater than the intrinsic value of the option at this node equal to $\text{Max}(0, 52-50)=2$ , so the option should not be exercised early at this node.

Question 28

Which of the following statements about American options is incorrect?

A. American options can be exercised at any time until maturity.
B. American options are always worth at least as much as European options.
C. American options can easily be valued with Monte Carlo simulation.
D. American options can be valued with binomial trees.

Question 29

Which of the following is an assumption of the Black-Scholes-Merton model?

A. Securities are traded in a frictionless market.
B. Short selling of securities is not possible
C. Only American style options are used
D. The underlying security’s price follows a normal distribution.

Answer: A
Assumption of the Black-Scholes-Merton model

The underlying price follows a lognormal probability distribution with $\mu$ and $\sigma$ held constant.
There are no transaction costs or taxes and all securities are perfectly divisible.
There are no dividends on the stock during the life of the options.
There are no riskless arbitrage opportunities.
Security trading is continuous.
Investors can borrow or lend at the same risk-free rate, which is constant through time.
The options being considered cannot be exercised early.

Question 30

What is the price of a three month European put option on a non-dividend-paying stock with a strike price of $ $50$ when the current stock price is $ $50$ , the risk-free interest rate is $10\%$ per annum, and the volatility is $30\%$ per annum.

A. 2.37
B. 2.48
C. 2.25
D. 2.63

Answer: A
In this case $S_0=50$ , $K = 50$ , $r = 0.1$ , $\sigma= 0.3$ , $T = 0.25$ .

$d_1=\frac{In(\frac{S_0}{K})+(r+\frac{\sigma^2}{2})T}{\sigma \sqrt{T}}=0.2417$

$d_2=d_1-\sigma \sqrt{T}= 0.0917$

The European put price is
$p=-S_0N(-d_1)+Ke^{-rT}N(-d_2)=-50\times0.4045+50\times e^{-0.1\times0.25}\times0.463=2.37$

Question 31

PE2018Q51 / PE2019Q51 / PE2020Q51 / PE2021Q51 / PE2022PSQ16 / PE2022Q51
An analyst wants to price a 1-year, European-style call option on company CZC’s stock using the Black-Scholes-Merton (BSM) model. CZC announces that it will pay a dividend of USD $0.50$ per share on an exdividend date 1 month from now and has no further dividend payout plans for at least 1 year. The relevant information for the BSM model inputs are in the following table.

Current stock price	USD $40$
Stock price volatility	$16\%$ per year
Risk-free rate	$3\%$ per year
Call option exercise price	USD $40$
$N(d_1)$	$0.5750$
$N(d_2)$	$0.5116$

What is the price of the 1-year call option on the stock?

A. USD $1.52$
B. USD $1.78$
C. USD $1.95$
D. USD $2.85$

Answer: D
Learning Objective: Compute the value of a European option using the Black-Scholes-Merton model on a dividend-paying stock, futures, and exchange rates.

The value of a European call is equal to

$S_0\times N(d_1)-Ke^{-rT}\times N(d_2)$

where $S_0$ is the current price of the stock. In the case that dividends are introduced, $S_0$ in the formula is reduced by the present value of the dividends.

The present value of the dividends equals to $0.5\times e^{-3\%/12} = 0.4988$

$S_0=40-0.4988=39.5012$

Call option price: $39.5012\times0.5750−40\times e^{-0.03\times 1}\times 0.5116= 2.85$

Question 32

A manager is responsible for the options desk in a London bank and is concerned about the impact of dividends on the options held by the options desk. The manager asks an analyst to assess which options are the most sensitive to dividend payments. What would be the analyst’s answer if the value of the options is found by using the Black-Scholes model adjusted for dividends?

A. Everything else equal, out-of-the-money call options experience a larger decrease in value than in-the-money call options as expected dividends increase.
B. The increase in the value of in-the-money put options caused by an increase in expected dividends is always larger than the decrease in value of in-the-money call options.
C. Keeping the type of option constant, in-the-money options experience the greatest absolute change in value and out-of-the-money options the smallest absolute change in value as expected dividends increase.
D. Keeping the type of option constant, at-the-money options experience the largest absolute change in value and out-of-the-money options the smallest absolute change in value as a result of dividend payment.

Question 33

An investor holds an American call option on a dividend paying stock with the following characteristics

Current stock price, $S=\text{USD}\;50$
Strike price, $K=\text{USD}\;50$
Time to expiration, $T=2\;\text{months}$

A divided, $D$ , of USD $1$ per share has just been announced, with an ex-dividend date, $t$ , of one month from now, Assuming the risk-free rate, $r$ , is $1.5\%$ and the option stays at-the-money, is it optimal to exercise the option right before the ex-dividend date?

A. Yes, because $K\times e^{-r(T-t)}+D$
B. Yes, because $D>K\times(1- e^{-r(T-t)})$
C. No, because the call option is at-the-money ,and
xercise is only optimal when it is deep in-the-money
D. No, because unlike an American put option, it is never optimal to exercise an American call option early.

Answer: B
When $S-D-Ke^{-r(T-t)}<S-K\to D>K(1- e^{-r(T-t)})$ , American call option will early exercise.

When $Ke^{-r(T-t)}-(S-D)<K-S\to D<K(1- e^{-r(T-t)})$ , American put option will early exercise.

Early exercise for American call options

The call option on no-dividends paying underlying should not be exercised before maturity if interest rates are positive.
Early exercising call option would yield a profit equal to intrinsic value. However, selling the option yields a profit of the intrinsic value plus time value.
Deep in the money call option with dividends may be early exercised. Exercising the option before an ex-dividend date would be the optimal decision.

Early exercise for American put options(holding stocks)

The decision to exercise an American put option without dividends is therefore a trade-off between
- Receiving the strike price early so it can be invested to earn interest.
- Benefiting from the optionality in circumstances where the stock price moves above the strike price.
In general, early exercising becomes less attractive to holder of a put option when:
- stock price increases
- interest rate decreases(reinvestment get less money)
- time to maturity increases
- Dividends expected during the life of the option increase.

Question 34

The CFO at a non-dividend-paying firm asks a financial analyst to evaluate a plan by the firm to grant stock options to its employees. The firm has $60$ million shares outstanding. Under the proposal, the firm would issue $3$ million employee stock options, with each option giving the holder the right to buy one share of the firm’s stock at a strike price of SGD $70$ . The employee stock options would expire in $4$ years. A four-year call option on the stock with the same strike price is currently valued at SGD $4.39$ using the Black-Scholes-Merton model. Which of the following is the best estimate of the price of one employee stock option assuming that the call option is correctly priced?

A. SGD $3.97$
B. SGD $4.18$
C. SGD $4.39$
D. SGD $4.45$

Answer: B
The value of each employee stock option is computed as:
$\frac{N}{N+M}\times\text{Call Option Value} =\frac{60,000,000}{60,000,000+3,000,000}\times4.39=4.1809$

Where $N$ is the total number of shares outstanding, and $M$ it the number of new shares (options) contemplated.

Question 35

Mr. Black has been asked by a client to write a large put option on the S&P 500 index. The option has an exercise price and a maturity that is not available for options traded on exchanges. He, therefore, has to hedge the position dynamically. Which of the following statements about the risk of his position are not correct?

A. He can make his portfolio delta neutral by shorting index futures contracts.
B. There is a short position in an S&P 500 futures contract that will make his portfolio insensitive to both small and large moves in the S&P 500.
C. A long position in a traded option on the S&P 500 will help hedge the volatility risk of the option he has written.
D. To make his hedged portfolio gamma neutral, he needs to take positions in options as well as futures.

Answer: B
The short index futures makes the portfolio delta neutral. It does not help with large moves.

Question 36

Which position is most risky?
A. Gamma-negative, delta-neutral
B. Gamma-positive, delta-positive
C. Gamma-negative, delta-positive
D. Gamma-positive, delta-neutral

Answer: C
A riskier position is one that is expected to move around a lot in value. A delta neutral position should not change in value as the value of the underlying asset changes. This eliminates Choice A and Choice D.
Choice C is correct because a gamma-negative position means that delta and the change in the underlying asset move inversely with each other.

Question 37

A portfolio of stock A and options on stock A is currently delta neutral, but has a positive gamma. Which of the following actions will make the portfolio both delta and gamma neutral?

A. Buy call options on stock A and sell stock A
B. Sell call options on stock A and sell stock A
C. Buy put options on stock A and buy stock A
D. Sell put options on stock A and sell stock A

Answer: D
To reduce positive gamma, one needs to sell options. When call options are sold, the delta becomes negative and one needs to buy stock to keep delta neutrality. When put options are sold, the delta becomes positive, and one needs to sell stock to keep delta neutrality.

Question 38

Which of the following choices will effectively hedge a short call option position that exhibits a delta of $0.5$ ?

A. Sell two shares of the underlying for each option sold.
B. Buy two shares of the underlying for each option sold.
C. Sell the number of shares of the underlying equal to one-half the options sold.
D. Buy the number of shares of the underlying equal to one-half the options sold.

Answer: D
In order to hedge a short call option position, a manager would have to buy enough of the underlying to equal the delta times the number of options sold. In this case, delta = 0.5, so for every two options sold, the manager would have to buy a share of the underlying security. (Stop-loss strategies with call options are designed to limit the losses associated with short option positions. The strategy requires purchasing the underlying asset for a naked call position when the asset rises above the option’s strike price.)

Question 39

PE2018Q53 / PE2019Q53 / PE2020Q53 / PE2021Q53
The current stock price of a company is USD $80$ . A risk manager is monitoring call and put options on the stock with exercise prices of USD $50$ and $5$ days to maturity. Which of these scenarios is most likely to occur if the stock price falls by USD $1$ ?

Scenario	Call Value	Put Value
A	Decrease by USD $0.07$	Increase by USD $0.89$
B	Decrease by USD $0.07$	Increase by USD $0.08$
C	Decrease by USD $0.94$	Increase by USD $0.08$
D	Decrease by USD $0.94$	Increase by USD $0.89$

Answer: C
Learning Objective: Describe the dynamic aspects of delta hedging and distinguish between dynamic hedging and hedge-and-forget strategy.

The call option is deep in-the-money.and must have a delta close to one.

The put option is deep. out-of-the-money and will have a delta close to zero.

Therefore, the value of the in-the-money call will decrease by close to USD $1$ , and the value of the out-of-the-money put will increase by a much smaller amount close to $0$ .

The choice that is closest to satisfying both conditions is C.

Question 40

PE2018Q37 / PE2019Q37 / PE2020Q37/ PE2021Q37 / PE2022Q37
A trader on the derivatives trading desk of an investment bank holds a portfolio of short option positions. The trader limits the risk of these exposures by maintaining a delta hedging strategy. In evaluating the dynamic nature of this strategy, which of the following is correct about the interest cost of carrying the delta hedge?

A. The interest cost of carrying the delta hedge will be highest when the options are deep out-of-the-money.
B. The interest cost of carrying the delta hedge will be highest when the options are deep in-the-money.
C. The interest cost of carrying the delta hedge will be lowest when the options are at-the-money.
D. The interest cost of carrying the delta hedge will be highest when the options are at-the-money.

Answer: B
Learning Objective: Describe the dynamic aspects of delta hedging and distinguish between dynamic hedging and hedge-and-forget strategy.

The deeper into-the-money the options are, the larger their deltas and therefore the more expensive to delta hedge.

Question 41

PE2018Q12 / PE2019Q12 / PE2020Q12 / PE2021Q12 / PE2022Q12
A risk manager on the derivatives trading desk of an investment bank is monitoring the sensitivity measures for several of the desk’s positions in options on stock FIR. The current market price of the stock is UsD $60$ . Which of the following options on stock FIR has the highest gamma?

A. Long call option expiring in $5$ days with strike price of USD $30$
B. Long call option expiring in $5$ days with strike price of USD $60$
C. Long call option expiring in $30$ days with strike price of USD $30$
D. Long call option expiring in $30$ days with strike price of USD $60$

Answer: B
Learning Objective: Define and describe theta, gamma, vega and rho for option positions and calculate the gamma and vega for a portfolio.

Gamma is defined as the rate of change of an option’s delta with respect to the price of the underlying asset, or the second derivative of the option price with respect to the asset price. Therefore the highest gamma is observed in shorter maturity and at-the-money options, since options with these characteristics are much more sensitive to changes in the underlying asset price.

The correct choice is a call option both at-the-money and with the shorter maturity.

Question 42

A bank has sold USD $300, 000$ of call options on $100, 000$ equities. The equities trade at $50$ , the option strike price is $49$ , the maturity is in $3$ months, volatility is $20\%$ , and the interest rate is $5\%$ . How does it the bank delta hedge? (round to the nearest thousand share)

A. Buy $65, 000$ shares
B. Buy $100, 000$ shares
C. Buy $21, 000$ shares
D. Seli $100, 000$ shares

Answer: A
Delta hedging the short call option position requires buying shares in an amount equal to the hedge ratio times the $100, 000$ shares underlying the call position. We can calculate the hedge. ratio as $N(d_1)$ from the Black Scholes option pricing model. First we need to compute $N(d_1)$ .
$d_1=\frac{In(\frac{S_0}{K})+(r+\frac{\sigma^2}{2})T}{\sigma \sqrt{T}}=0.377$

We know that $N (0.377)$ has to be between $0.5$ and $1.0$ , which means we need to buy somewhere between $50, 000$ and $100, 000$ shares. The only answer that fits is A, buy $65, 000$ shares. If you did have access to a probability table, you could determine that $N (0.377) = 0.6469$ , which means we need to buy exactly $64, 690$ shares to delta hedge the position.

Question 43

Initially, the call option on Big Kahuna Inc. with $90$ days to maturity trades at USD $1.40$ . The option has a delta of $0.5739$ . A dealer sells $200$ call option contracts, and to delta-hedge the position, the dealer purchases $11, 478$ shares of the stock at the current market price of USD $100$ per share. The following day, the prices of both the stock and the call option increase. Consequently, delta increases to $0.7040$ . To maintain the delta hedge, the dealer should:

A. sell $2602$ shares
B. sell $1493$ shares
C. purchase $1493$ shares
D. purchase $2602$ shares

Answer: D
Changes of Stock number: $0.5739)\times200\times100 = 2602$

Question 44

A risk manager is evaluating an option portfolio that has been hedged to satisfy a risk limit.
All other things being equal, which of the following portfolio characteristics will typically result in a need to rebalance the hedge more frequently to remain in compliance?

A. Small delta value
B. Large delta value
C. Large theta value
D. Large gamma value

Question 45

If risk is defined as a potential for unexpected loss, which factors contribute to the risk of a short call option position?

A. Delta, Vega, Rho
B. Vega, Rho
C. Delta, Vega, Gamma, Rho
D. Delta, Vega, Gamma, Theta, Rho

Answer: C
For a short call, Delta Vega, Gamma, and Rho contribute to the risk of the position. Theta is not a risk factor.

Question 46

Which of the following statements is correct?

I. The rho of a call option changes with the passage of time and tends to approach zero as expiration approaches, but this is not true for the rho of put options.
II. Theta is always negative for long calls and long puts and positive for short calls and short puts.

A. I only.
B. Il only
C. I and II
D. Neither

Answer: D
Statement I is false - tho of a call and a put will change, with expiration of time and it tends to approach zero as expiration approaches.

Question 47

Which of the following statements is true regarding options Greeks?

A. Theta tends to be large and positive when buying at-the-money options.
B. Gamma is greatest for in-the-money options with long maturities.
C. Vega is greatest for at-the-money options with long maturities.
D. Delta of deep in-the-money put options tends toward +1.

Answer: C
Theta is negative for long positions in ATM options, so A is incorrect. Gamma is small for ITM options, so B is incorrect. Delta of ITM puts tens to -1, so D is incorrect.

Question 48

Consider the following statements, which one is incorrect?

A. Short a coupon bond is equivalent to long effective duration and short effective convexity.
B. Long a plain vanilla call option is equivalent to long delta and also long gamma.
C. Short a plain vanilla put option is equivalent to short vega.
D. Long a deep in the money up and out call option is equivalent to long delta and short vega.

Question 49

Portfolio manager Sally has a position in 100 option contracts with the following position Greeks: theta = +25,000; vega = +330,000 and gamma = -200; ie., positive theta, positive vega and negative gamma. Which of the following additional trades, utilizing generally at-the-money (ATM) options, will neutralize (hedge) the portfolio with respect to theta, vega and gamma?

A. Sell short-term options + sell long-term options (all roughly at-the-money)
B. Sell short-term options + buy long-term options (~ ATM)
C. Buy short-term options + sell long-term options (~ ATM)
D. Buy short-term options + buy long-term options (~ ATM)

Answer: C
For ATM options, vega and theta are increasing funtions with maturity; and gamma is a decreasing function with matutity.

To buy short-term options + sell long-term options 2 negative position thera, negative position vega, and positive position gamma.

In regard to (A), sell short-term + seil long-term options 2 positive thera, negative vega; negative gamma.

In regard to (B), sell short-term + buy long-term options 2 positive thera, positive vega; and negative gamma.

In regard to (D), buy short-term + buy long-term > negative thera, positive vega; and positive gamma.

Note: the above are approximately actual number for 100 option contracts (100 options each = 10,000 options) with the following properties: Strike = Stock = $100; volatility = 15.0%, risk-free rate = 4.0%; term = 1.0 year. Under these assumptions:

a) 1-year term: percentage theta = -5.0, vega = +37, gamma = +0.025

b) 10-year term:percentage theta = -2.5, vega = +70, gamma = +0.005

Question 50

An option portfolio exhibits high unfavorable sensitivity to increases in implied volatility and while experiencing significant daily losses with the passage of time. Which strategy would the trader most likely employ to hedge his portfolio?

A. Sell short dated options and buy long dated options
B. Buy short dated options and sell long dated options
C. Sell short dated options and sell long dated options
D. Buy short dated options and buy long dated options

Answer: A
Such a portfolio is short vega (volatility) and short theta (time). We need to implement a hedge that is delta-neutral and involves buying and selling options with different maturities. Long positions in short-dated options have high negative theta and low positive vega. Hedging can be achieved by selling short-term options and buying long-term options.

Question 51

PE2018Q74 / PE2019Q74 / PE2020Q74 / PE2021Q74 / PE2022Q74
Company XYZ operates in the U.S. On April 1, 2009, it has a net trade receivable of EUR $5, 000, 000$ from an export contract to Germany. The company expects to receive this amount on Oct. 1, 2009. The CFO of XYZ wants to protect the value of this receivable. On April 1, 2009, the EUR spot rate is USD $1.19$ per EUR $1$ , and the $6$ -month EUR forward rate is USD $1.17$ per EUR $1$ . The CFO can lock in an exchange rate by taking a position in the forward contract. Alternatively, he can sell a $6$ -month EUR $5, 000, 000$ call option with strike price of $1.19$ per EUR $1$ .

In assessing the potential hedging strategy, the CFO thinks that selling an option is better than taking a forward position because if the EUR goes up, XYZ can take delivery of the USD at USD $1.19$ per EUR $1$ , which is better than the outright forward rate of $1.17$ . If the EUR goes down, the contract will not be exercised. So, XYZ will pocket the premium obtained from selling the call option.

What can be concluded about the CFO’s analysis?

A. CFO’s analysis is correct. The company is better off whichever way the EUR rate goes.
B. CFO’s analysis is not correct. The company will suffer if the EUR goes up sharply.
C. CFO’s analysis is not correct. The company will suffer if the EUR moves within a narrow range.
D. CFO’s analysis is not correct. The company will suffer if the EUR goes down sharply.

Answer: D
Learning Objective: Describe the types, position variations, and typical underlying assets of options.

The CFO’s analysis is incorrect because there is unlimited downside risk. The option premium received is a fixed amount, and if the EUR declines sharply, the value of the underlying receivable goes down as well. If instead the EUR moves in a narrow range, that would be good, but there is no guarantee of course that this will occur.

Question 52

PE2019Q52 / PE2020Q52 / PE2021Q52
The CFO at a non-dividend-paying firm asks a financial analyst to evaluate a plan by the firm to grant stock options to its employees. The firm has $60$ million shares outstanding. Under the proposal, the firm would issue $3$ million employee stock options, with each option giving the holder the right to buy one share of the firm’ stock at a strike price of USD $70$ . The employee stock options would expire in $4$ years. A four-year call option on the stock with the same strike price is currently valued at SGD $4.39$ using the Black-Scholes-Merton model.

Which of the following is the best estimate of the price of one employee stock option assuming that the call option is correctly priced?

A. SGD $3.97$
B. SGD $4.18$
C. SGD $4.39$
D. SGD $4.45$

Answer: B
Learning Objective: Describe warrants, calculate the value of a warrant and calculate the dilution cost of the warrant to existing shareholders.

B is correct. The value of each employee stock option is computed as:

$\cfrac{N}{N+M} \times(\text{Call Option Value})=\cfrac{60000000\times4.39}{60000000+3000000}=4.1809$

Where:
$N =$ total number of shares outstanding
$M =$ number of new shares (options) contemplated

Question 53

PE2022Q53
A derivative trading firm that previously used only the Black-Scholes-Merton (BSM) model to value options has recently decided to use the binomial tree option pricing model as well. An analyst at the firm is reviewing the different features of the two models to compare and contrast their inputs and assumptions. In comparing the two models, which of the following statements is correct?

A. The BSM model uses an underlying asset’s implied volatility as an input but the binomial tree approach uses its historical volatility.
B. The binomial tree approach, but not the BSM model, assumes that the expected return from the underlying asset is the risk-free rate of interest.
C. In the binomial tree approach, delta is equal at each node since the probabilities of the price moving up or down during a period are constant and equal for both the underlying asset and the option.
D. If the assumptions of the BSM model hold, the implied volatility of a longer-term option and the implied volatility of a shorter-term option on the same underlying asset will be the same.

Answer: D
Learning Objective:

Calculate the value of an American and a European call or put option using a one-step and two-step binomial model.
Describe the assumptions underlying the Black-Scholes-Merton option pricing model.
Define and calculate delta of a stock option.
Define implied volatilities and describe how to compute implied volatilities from market prices of options using the Black-Scholes-Merton model.

D is correct. If all the BSM model assumptions hold, then all options on the same underlying asset will have the same implied volatility at all times.

A is incorrect. Both the BSM model and the binomial tree approach use asset volatility computed from historical prices.

B is incorrect. Both the BSM model and the binomial tree approach use the risk-neutral valuation, that is, assume that the expected return from the underlying asset is the risk-free rate of interest.

C is incorrect. In the binomial tree approach, delta does not remain constant at every node (through time) even though the approach takes the probability of the price moving up and the probability of the price moving down not to change during a given period.

Question 54

PE2022Q86
A portfolio manager is calculating the realized return and the historical volatility of returns for the stock of company VMG. The stock ended the month of June 2021 at a price per share of INR $280$ , and ended the month of December 2021 at INR $320$ . The manager reports that the monthly volatility of the stock returns over the 6-month period was $2.76\%$ . Assuming continuous compounding, and that the stock’s returns are independent over time, what are the realized return over the 6-month period and the volatility of the stock returns per year?

A. The realized return is $12.5\%$ , and the annual volatility is $9.6\%$ .
B. The realized return is $12.5\%$ , and the annual volatility is $33.1\%$ .
C. The realized return is $26.7\%$ , and the annual volatility is $9.6\%$ .
D. The realized return is $26.7\%$ , and the annual volatility is $33.1\%$ .

Answer: C
Learning Objective: Compute the realized return and historical volatility of a stock.

C is correct.
Given: $T = 6$ months $= 6/12 = 0.5$ , $S_0 = 280$ , $S_T= 360$

Therefore,
Realized return $\cfrac{1}{T}\times \text{In}(\cfrac{S_T}{S_0}) = 2 \times \text{In}(\cfrac{320}{280}) = 26.7\%$

Volatility per year $s\times \sqrt{\Delta t} = 0.0276\times \sqrt{12} =9.6\%$

A is incorrect. $12.5\%$ incorrectly calculates the realized return on the stock as the price change over the period divided by the price at the end of the period ( $40/320$ ).

B is incorrect. $33.1\%$ ( $2.76\% \times 12$ ) is the result of not using the square root rule to determine the annual volatility. The return of $12.5\%$ is calculated as described in A above.