Question

1. Briefly explain the difference between the underlying asset and the exercise price of the option.

2. Distinguish the following option scenarios with respect to intrinsic value: In the money, At the money  and Out of the money.

3. Briefly explain two main option pricing/valuation models, namely, Black-Scholes model and Binomial model, respectively.

4. Compare and contrast securitization and credit derivatives.

Answer 1

Q1) Underlying asset is the asset from which the derivaties derives its value.

Exercise price of an option is the price at which the owner of the option is entitled to buy or sell the underlying security.

Q2) In the money Option is when the option is providing you a profit. It depends on the position of strike price relative to the market value of the stock . In case of call option, if strike price is less than market value then the option is in the money and vice versa for put option.

At the money mean when the option is neither providing you a profit nor a loss. It is when the strike price and market value is same.

Out of the money option refers to a situation when the option is making a loss. In case of call option, it is out of money when strike price is more than market value. whereas in case of put it occurs when market value is more than strike price.

Q3) Black Scholes model is a pricing model used to determine the fair price or theoretical value for a call or a put option based based on six variables such as risk free rate, volatility, strike price, stock price, time and type of option.

Binomial option pricing model is used to value multiple period options. There are two possible outcome with each iteration i.e. up move and down move . The model is based on assumptions and is more frequently used than Black Scholes model.

Q4) Secutitization is a process by which a company clubs the different types of debt instruments to form a consolidated financial instrument and sells it to investors. This helps to imptoves the credit rating of the company.

Credit derivative is a financial instrument which helps to transfer the risk of non payment to a party other than the lender. This protects the investors against any default.