Question

A. When is the best time to exercise the call option and put option strategy? Justify.
B. What is risk-neutral valuation? Expound.

Answer 1

A)

When you sell an option, the most you can profit is the price of the premium collected, but often there is unlimited downside potential. When you purchase an option, your upside can be unlimited and the most you can lose is the cost of the options premium.

A call option buyer stands to make a profit if the underlying asset, let's say a stock, rises above the strike price before expiry. A put option buyer makes a profit if the price falls below the strike price before the expiration. The exact amount of profit depends on the difference between the stock price and the option strike price at expiration or when the option position is closed.

B)

It is a method for valuing financial assets. Risk-neutral valuation calculates the value of an asset by discounting the expected value of its future pay-offs at the risk-free rate of return. The expected value is not obtained using the actual probabilities of each pay-off. Instead, risk-neutral valuation calculates the expected value of future pay-offs using constructed probabilities that have the property of rationalizing observed asset prices if all investors were risk-neutral.