Free CDP Pricing & Valuation Questions and Answers — Questions and Answers
Question 1: Which of the following is least likely a factor in the pricing of derivatives?
- Risk-free rate
- Risk premium required by the investor (Correct answer)
- Any benefits or costs associated with holding the underlying
- Time to expiration
Correct answer: Risk premium required by the investor
Derivative pricing models, such as the Black-Scholes model, typically rely on factors like the underlying asset's price, strike price, time to expiration, volatility, and the risk-free interest rate. While an investor's individual risk premium influences their decision to buy or sell, it is not a direct input into the theoretical pricing of the derivative itself. Derivative pricing assumes a risk-neutral world for calculation purposes.
Question 2: What is the intrinsic value of a call option?
- The premium paid for the option
- The difference between the strike price and the underlying asset's price
- The amount by which the option is in-the-money (Correct answer)
- The time value of the option
Correct answer: The amount by which the option is in-the-money
The intrinsic value of a call option is the immediate profit an option holder would realize if they exercised the option right now. For a call option, this occurs when the underlying asset's price is higher than the strike price. Specifically, it is calculated as the greater of (underlying asset price - strike price) or zero, representing the "in-the-money" portion.
Question 3: Which model is commonly used to price European options?
- Monte Carlo simulation
- Binomial model
- Black-Scholes model (Correct answer)
- CAPM model
Correct answer: Black-Scholes model
The Black-Scholes model is a widely recognized and fundamental mathematical model used to estimate the theoretical price of European-style options. It takes into account factors like the underlying asset's price, strike price, time to expiration, volatility, and the risk-free interest rate. While other models exist, Black-Scholes is a cornerstone for European option valuation.
Question 4: What does the 'Delta' of an option represent?
- Time decay of the option's value
- Change in option price for a $1 change in the underlying asset's price (Correct answer)
- Volatility of the underlying asset
- Interest rate sensitivity of the option
Correct answer: Change in option price for a $1 change in the underlying asset's price
Delta is one of the "Greeks" in option pricing and measures the sensitivity of an option's price to a change in the underlying asset's price. A delta of 0.50 for a call option, for instance, means the option's price is expected to increase by $0.50 for every $1 increase in the underlying asset's price. It is a crucial measure for hedging and understanding an option's directional exposure.
Question 5: In the context of option pricing, what does 'Theta' measure?
- Sensitivity to interest rate changes
- Sensitivity to volatility changes
- Time decay of the option's value (Correct answer)
- Sensitivity to changes in the underlying asset's price
Correct answer: Time decay of the option's value
Theta, another of the "Greeks," measures the rate at which an option's value erodes over time, assuming all other factors remain constant. As an option approaches its expiration date, its time value decreases, and Theta quantifies this daily decay. This is because there is less time for the underlying asset's price to move favorably for the option holder.
Free CDP Pricing & Valuation Questions and Answers
Which of the following is least likely a factor in the pricing of derivatives?