SHORT QUESTIONS

1. What is a derivative, how does it differ from a stock or bond? (4%)

2. How do price limits work with futures? Do all futures contracts have limits? (4%)

3. What is the definition of a call option? (4%)

4. What is the difference between an American and European option? (4%)

5. Are exchange-listed options adjusted for the payment of an ordinary dividend?

6. Do buyers of call options have to post margin? Why is this? (4%)

7. What is meant by the term ‘naked’ in relation to options? (4%)

8. Is the delta of a long call option positive or negative? (4%)

9. Define Vega, how does an increase in volatility affect the price of call options? (4%)

10. Using just a call option (which controls 100 shares) with a delta of 0.5 and the underlying
stock, how might you put on a delta neutral position that is long volatility? (4%)

LONG QUESTIONS (20%)

11. (Part 1) Using the formula for Put Call Parity, what combination can you make of options
positions and the underlying to replicate a short put position?

(Part 2) Define a Bear Spread. What kind of market move are you hoping for if you are
long a bear spread? Can it be constructed using puts or calls, or both?

12. Use a 2 step binomial tree to value a put option. (20%)

All of the steps in your calculation should be shown including the calculation of P and
the calculation of each of the option nodes U, D, UU, UD & DD.

 Assume that at each node the stock moves up 20% or down 20%

 The option expires in 2 years. The interest rate is 5% continuously compounded.

 The spot price is 100 and the option strike price is 104

 Early Exercise is not possible with this option.

13. Explain in your own words what dynamic hedging is, and how a trader could profit by
dynamically hedging an option if they have a forecast of volatility that is different to implied
volatility. (20%)