FNCE30007 Final Exam

What is a derivative?

A financial instrument whose value is derived from an underlying asset.

What is the difference between a forward and a futures contract?

A forward is privately negotiated OTC; a futures contract is standardised and exchange-traded

What is the difference between a call and a put option?

A call gives the right to buy; a put gives the right to sell.

What is the difference between a European and American option?

A European option can only be exercised at expiry; an American option can be exercised any time up to expiry.

What is the difference between hedging and speculation?

Hedging reduces existing risk; speculation takes on risk to profit from price movements.

What is basis risk?

The risk that the spot price and futures price do not move together as expected.

What is the cost of carry?

The net cost of holding an asset until a future date, including financing and storage costs, less income earned.

What is marking to market?

The daily settlement of futures gains and losses through margin accounts.

What is the difference between initial margin and maintenance margin?

Initial margin is the amount deposited when opening a futures position; maintenance margin is the minimum balance required.

What is the difference between a long and short futures position?

Long agrees to buy and benefits from rising prices; short agrees to sell and benefits from falling prices.

What is an option's intrinsic value?

The immediate exercise value: max(S − K, 0) for a call or max(K − S, 0) for a put.

What is an option's time value?

The option premium minus intrinsic value, reflecting the possibility of future gains.

What is put-call parity?

The no-arbitrage relationship linking European call and put prices with the underlying asset and risk-free investment.

What is arbitrage?

Trading to earn a risk-free profit from inconsistent prices, with no net initial investment in a standard arbitrage setup.

What is the no-arbitrage principle?

Two portfolios with identical future payoffs must have the same price today.

What is risk-neutral valuation?

Pricing derivatives using risk-neutral probabilities and discounting expected payoffs at the risk-free rate.

What is the risk-neutral probability?

The probability of an up or down movement implied by the risk-free rate and asset-price movements, used for derivative pricing rather than forecasting actual outcomes.

What is backward induction in a binomial model?

Starting with option payoffs at expiry and working backwards to calculate earlier option values.

How is an American option valued at each binomial node?

Take the maximum of immediate exercise value and continuation value.

What is the difference between an American and European option's exercise decision?

An American option may be exercised early; a European option cannot be exercised before expiry.

What is the Black-Scholes-Merton (BSM) model?

A model used to value European options using the underlying price, strike, time, volatility and interest rate, with dividends included when relevant.

How does volatility affect option prices?

Higher volatility generally increases both call and put values because it increases potential favourable price movements.

What is delta?

The sensitivity of an option's value to a change in the underlying asset price.

What is delta hedging?

Adjusting a position in the underlying asset to offset the option position's price sensitivity.

What is gamma?

The rate at which delta changes when the underlying asset price changes.

What is vega?

The sensitivity of an option's value to a change in volatility.

What is theta?

The sensitivity of an option's value to the passage of time, holding other variables constant.

What is rho?

The sensitivity of an option's value to a change in the risk-free interest rate.

What is a forward rate agreement (FRA)?

An OTC contract that locks in an interest rate for a future borrowing or lending period.

What is the difference between a payer and receiver interest rate swap?

A payer swap pays fixed and receives floating; a receiver swap receives fixed and pays floating.