Derivatives - Options
Basics of Options (CFA Level I Suggested Reading)
- Basic characteristics of option contracts
- European option, American option, and moneyness
- Types of options in terms of the underlying instruments
- Comparison of interest rate options with FRAs, and other types of options
- Characteristics of interest rate caps and floors
- Bounds on the minimum and maximum values of European options and American options
- Impact of exercise price, time to expiration, and interest rates on premium of an option
- Concept of put-call parity for European options
- Differences between American options and European options caused by the possibility of early exercise
- Impact of dividends on put-call parity and lower bounds of option prices
Option Markets and Volatility (CFA Level II Suggested Reading)
- Options on most major stocks are traded on derivatives exchanges
- All features of stock options are standardised by the exchange
- A stock index is a benchmark that tracks the performance of the stock market or a segment within the market
- Foreign exchange transactions can be viewed as the sale/purchase of the base currency with the price being paid in the terms currency
- Futures are exchange-traded derivatives contracts that enable their owner to buy/sell an asset at a specified price on a specified date in the future
- Understand Eurodeposits
- Know what kind of options are traded where
- Volatility is the measure of the movement in the price of an asset
- The historical volatility of the return from an asset is the standard deviation of the returns over the calculation period
- Implied volatility is the level of volatility that is implied in the prices of traded options
- If the forecast volatility is lower than the implied volatility, then you should take a short position on volatility by selling options
- Implied volatility is model specific, e.g. Black-Scholes volatility can only be used with the Black-Scholes model
Option Valuation and Risk Management
- Understand what the intrinsic value of an option is
- The one-step pricing model begins with the projection of the asset price into the future based on the expected volatility
- Understand what the terminal value of the option is
- Understand the binomial model
- Study of the Black-Scholes model
- Market risk is the risk of a loss due to movements in the financial markets
- The delta of an option is the rate of change in its value with respect to the underlying asset price
- The gamma of an option is the rate of its delta with respect to the underlying asset price
- The vega of an option is the rate of change in its value with respect to the volatility of the underlying asset price
- Theta is the rate at which option value changes over time if all other parameters remain constant
- The rho of an option is the rate of change in its value with respect to the change in interest rates
- The credit risk due to an option is inherently asymmetric: the option buyer has credit exposure to the option seller, but the option seller has no credit exposure once the option buyer has paid the premium
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