IMC Financial Analysis & Derivatives 2

Question 1

What does 'intrinsic value' mean for an option?

Accepted Answer

The amount by which an option is 'in the money' — the difference between the current asset price and the strike price

Answer

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?

Accepted Answer

The market's expectation of future volatility implied by the current market price of an option

Answer

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?

Accepted 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

Answer

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?

Accepted Answer

The rate of change of an option's price relative to a £1 change in the price of the underlying asset

Answer

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?

Accepted Answer

Taking an offsetting position in a related instrument to reduce or eliminate the risk of adverse price movements in an existing position

Answer

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.

IMC Practice Test

IMC Practice Test

IMC Financial Analysis & Derivatives 2