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CFA Derivatives financial instruments that derive their value from the value of some underlying asset i have become increasingly important and fundamental in effectively managing financial risk and creating synthetic exposures to asset classes. As in other security markets, arbitrage and market efficiency play a critical role in establishing prices.
2. Variables affecting Option Prices
European Call European Put American Call American Put
Variable
c=Max(S-X,0) p=Max(X-S,0) C=Max(S-X,0) P=Max(X-S,0)
Current Stock Price
+ - + -
(St)
Strike Price (X) - + - +
Time to Expiry (T) ? ? + +
Volatility (Sigma) + + + +
Risk Free Rate (r) + - + -
Dividends (D) - + - +
X
Put-Call Parity: ct (T t)
p t St PV(D) where PV(D) is the present value
(1 r) of the dividend paid in future
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3. Concept Checkers
1. If the volatility of the underlying asset decreases, then the:
A. Value of the put option will increase, but the value of the call option will decrease
B. Value of the put option will decrease, but the value of the call option will increase
C. Value of both the put and call option will decrease
2. Which of the following features increase the value of a call option?
A. High interest rate
B. Highly variable stock price
C. All of the above
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4. Answers
1. C, with the increase in the volatility, the price of all the options increases
2. C, high interest rate and high volatility increase the price of the call option
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