8006 – Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

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Showing 10–12 of 15 questions

Question 10

If the implied volatility is known for a call option, what can be said about the implied volatility for a put option with the same strike and maturity?

Select an option, then click Submit answer.

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The implied volatility for the put will be the same as that for the call but with a negative sign
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The implied volatility for the put will be the same as that for the call
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The implied volatility for the put will be given by the expression [1 - ] where is the implied volatility for the call
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The implied volatility for the put cannot be determined from the implied volatility of the call

Question 11

The rate of dividend on a stock goes up. What is the effect on the price of a call option on this stock?

Select an option, then click Submit answer.

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It may affect the call value either way depending upon the risk-free rate
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It decreases the value of the call
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It increases the value of the call
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It does not affect the value of the call

Reference / correct answer:

It decreases the value of the call

Everything else remaining the same, an increase in the rate of dividends causes the value of call options to fall and the value of put options to rise. Therefore, Choice 'b' is the correct answer. (In the exam, the question could address either a call or a put option, so be aware of the answer in either case).

To understand this, consider how dividends are accounted for when valuing an option using the Black Scholes model. Future dividends are discounted to the present using the risk free rate and this discounted value is reduced from the spot price used in the BSM valuation. Effectively, this reduces the spot price used in the BSM formula. When the spot price reduces, and the exercise price remains the same, then the value of the call option goes down. In the same way, when spot price is reduced by the present value of dividends (and the exercise price stays the same), obviously the put option becomes more valuable.

Therefore an increase in the rate of dividends increases the value of the put option. There is another intuitive way to think about this: A call option is like a long position in the stock, but the holder of the call option is not entitled to receive dividends (unlike the holder of the stock). Since the holder of the call option has to forego the dividends, he is willing to pay less for the option; or in other words, the value of the call reduces.

In the same way, a put option is like having a short position in the stock. The holder of the short position has to borrow the stock in order to get into the short position in the first place. When dividends are paid, the holder of the short stock position has to make good any dividends that might be paid to the lender of the stock. The holder of a put option does not have to make any such payments. Therefore the put option is more valuable, and the existence of dividends (or an increase in dividends) increases the value of the put option.

(Try this out using the Black Scholes Excel model given under the tutorials by varying the spot price.)

Question 12

Which of the following statements are true:

I. Forward prices for a stock will fall if dividend expectations increase for the period thecontract is alive

II. Three month forward prices will decline if the 10 year rate goes up, and short term ratesstay unchanged

III. Futures exchanges require buyers but not sellers to deposit initial margins

IV. Variation margin is to be deposited when a futures contract is entered into

V. Futures exchanges requires hedgers and speculators to deposit identical margins

VI. Interest rate futures contracts carry duration but no convexity due to the daily cashsettlements

Select an option, then click Submit answer.

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I and IV
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I
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II and III
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I, II, V and VI
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Forward prices for a stock will fall if dividend expectations increase for the period thecontract is alive

II. Three month forward prices will decline if the 10 year rate goes up, and short term ratesstay unchanged

III. Futures exchanges require buyers but not sellers to deposit initial margins

IV. Variation margin is to be deposited when a futures contract is entered into
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Futures exchanges requires hedgers and speculators to deposit identical margins

VI. Interest rate futures contracts carry duration but no convexity due to the daily cashsettlements

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