Reading Assignments

   Chapter 12: All but follow objectives carefully
   Chapter 13: Pp. 381-385, 393-397, 399-402
   Chapter 14: Pp. 422-434

Objectives  

Chapter 12: Bounds on Option Prices

  1. Use symbols and notation relative to option pricing correctly.
  2. State the difference between American options and European options.
  3. Explain what additional calculation is needed for European options
       when calculating the value of an option before expiration.
  4. Explain what is meant by the intrinsic value of an option.
  5. Explain what is meant by the time value of an option and give a 
       synonym.
  6. Calculate the intrinsic value and time value of an option given its
       quotation from the Wall Street Journal.
  7. State and explain the minimum value of a call.
  8. State and explain the maximum value of a call.
  9. State and explain the value of a call at expiration.
*10. Give a diagram illustrating the relationship between the intrinsic value
       and time value of a call, stock price, and exercise price.
*11. State and explain the general correlation between the value of a call and:
       a) time to expiration 		
       b) the exercise (strike) price 	
       c) dividends 				
       d) risk-free interest rate
       e) current stock price
       f) stock price volatility
 12. State and explain the minimum value of a put.
 13. State and explain the maximum value of a put.
 14. State and explain the value of a put at expiration.
*15. Give a diagram illustrating the relationship between the intrinsic value 
       and time value of a put, stock price, and exercise price.
*16. State and explain the general correlation between the value of a put and:
       a) time to expiration   		
       b) the exercise (strike) price 	
       c) dividends 	
       d) risk-free interest rate
       e) current stock price
       f) stock price volatility

Chapter 13: European Option Pricing

Binomial Model

  17. Explain why the binomial model is called the binomial model.
* 18. Describe with a diagram, equations, assumptions, and a 
        narrative what is meant by the two-state model for option 
        pricing; include equations for the possible stock prices at 
        the end of period and for the possible call prices at the end 
        of the period.
* 19. Describe the riskless hedge portfolio (equivalent to a riskless 
        Treasury security) used in deriving the binomial model for 
        option pricing, i.e., what is in the portfolio and what the 
        relative amounts are.
  20. Give an equation that shows the value of the hedge portfolio 
        at any time and its possible values at expiration.
  21. State what the return on the hedge portfolio should be and why.
  22. Give the equation for the binomial option pricing model with an 
        explanation of what each of the symbols stands for.
* 23. Give the binomial option pricing model in words.
  24. Explain why the binomial model is unrealistic.
  25. Relate the expiration value of the hedge portfolio to the price
        movement of the underlying stock if the portfolio is truly 
        hedged.
*I26. Using any references desired and given numbers for variables,
        calculate the value of a call using the binomial model as 
        well as the hedge ratio.
  27. Explain what exactly is meant by the hedge ratio.
  28. Explain how traders would use the price calculated by the 
        binomial model (or any other model) in their trading, i.e., 
        why traders are interested in calculating the theoretical 
        value of a call (or any other option).

 Black-Scholes Model

  29. Describe the hedge portfolio used in the Black-Scholes model.
  30. State what the return on the hedge portfolio should be and why.
  31. State the assumption in the Black-Scholes option pricing model 
        about the distribution of the rates of return on stocks.
* 32. Draw a diagram of a normal distribution and of a lognormal 
        distribution.
*I33. Using any references desired and given numbers for variables,
        calculate the value of a call using the Black-Scholes model 
        as well as the hedge ratio.
  34. State the five variables in the Black-Scholes model which
       affect the option's price.
  35. State which three of the five variables can be observed.
  36. State how the risk-free rate is obtained for the model.
 

Chapter 14: Option Sensitivities and Option Hedging

* 37. Explain what is meant by a call's delta including: 
	   a) definition
 	   b) possible values
        c) approximate values for deep-out-of-the-money 
           and deep-in-the-money options
        d) how it relates to the hedge ratio
        e) how it can be used to construct the hedge portfolio.
* 38. Explain what is meant by a call's gamma including: 
        a) definition
        b) possible values
        c) how delta (and hence gamma) changes with changes in stock 
           prices
        d) what gamma measures
        e) what that implies about adjusting the hedge portfolio
        f) approximate values of gamma for deep-out-of-the-money and 
           deep-in-the-money options
        g) the correlation between the size of gamma and the frequency 
           with which the hedge portfolio must be adjusted
        h) how gamma changes as the time to expiration gets short 
           (assuming the option is at-the-money).
  39. Explain what is meant by a call's vega including:
        a) definition
        b) the sensitivity of a call's price to changes in volatility
        c) why vega is useful.
  40. State the delta, gamma, and vega of a portfolio of options.
  41. State the delta, gamma, and vega for a stock.