IMC Financial Analysis & Derivatives 2 — Questions and Answers
Question 1: What does 'intrinsic value' mean for an option?
- The total value of the option including time value
- The amount by which an option is 'in the money' — the difference between the current asset price and the strike price (Correct answer)
- The value of the underlying asset
- The present value of the option's future cash flows
Correct answer: The amount by which an option is 'in the money' — the difference between the current asset price and the strike price
Intrinsic value is the immediate exercise value of an option: for a call, it is max(0, Asset Price - Strike Price); for a put, it is max(0, Strike Price - Asset Price). An option with positive intrinsic value is 'in the money'. Total option value = intrinsic value + time value.
Question 2: What is 'implied volatility' in options pricing?
- The historical volatility of the underlying asset
- The market's expectation of future volatility implied by the current market price of an option (Correct answer)
- The volatility of the option's own price
- The volatility implied by a company's earnings growth
Correct answer: The market's expectation of future volatility implied by the current market price of an option
Implied volatility is extracted from current option market prices using an options pricing model (like Black-Scholes). It represents the market's consensus expectation of how volatile the underlying asset will be over the option's lifetime. High implied volatility means more expensive options.
Question 3: What is an 'interest rate swap' and its most common use?
- An agreement to exchange a fixed currency for a floating currency
- An agreement where two parties exchange fixed and floating interest rate payments on a notional principal, most commonly used to manage interest rate exposure (Correct answer)
- A swap of different currencies at prevailing exchange rates
- An exchange of equity dividends for bond coupons
Correct answer: An agreement where two parties exchange fixed and floating interest rate payments on a notional principal, most commonly used to manage interest rate exposure
In a plain vanilla interest rate swap, one party pays a fixed rate while receiving a floating rate (e.g., SONIA) from the other party, on an agreed notional amount. They are used to convert fixed-rate borrowing to floating or vice versa, managing interest rate risk.
Question 4: What is the 'delta' of an option?
- The change in option price resulting from a 1% change in volatility
- The rate of change of an option's price relative to a £1 change in the price of the underlying asset (Correct answer)
- The time decay of an option's value
- The change in option price from a 1% change in interest rates
Correct answer: The rate of change of an option's price relative to a £1 change in the price of the underlying asset
Delta measures an option's sensitivity to changes in the underlying asset's price. A delta of 0.5 means the option price changes by £0.50 for every £1 move in the underlying. Delta ranges from 0 to 1 for calls and -1 to 0 for puts.
Question 5: What is 'hedging' in investment management?
- Making aggressive directional bets to enhance returns
- Taking an offsetting position in a related instrument to reduce or eliminate the risk of adverse price movements in an existing position (Correct answer)
- Selling all risky assets and holding cash
- Using leverage to amplify returns
Correct answer: Taking an offsetting position in a related instrument to reduce or eliminate the risk of adverse price movements in an existing position
Hedging involves taking a position in a derivative or related asset that offsets (reduces) an existing risk. For example, buying put options to protect a long equity portfolio against a market fall. Perfect hedging eliminates risk but also eliminates upside.
Question 6: What is 'gamma' in options risk management?
- The change in delta resulting from a £1 change in the underlying asset price (Correct answer)
- The total profit and loss of an options portfolio
- The implied volatility of an option
- The option's time value
Correct answer: The change in delta resulting from a £1 change in the underlying asset price
Gamma measures the rate of change of an option's delta for a £1 change in the underlying asset. High gamma means delta changes rapidly, making the option's price behaviour more unpredictable. Gamma is highest for at-the-money options close to expiry.
IMC Financial Analysis & Derivatives 2
What does 'intrinsic value' mean for an option?