Some firms face risks that they cannot efficiently hedge using plain vanilla options. This motivates them to resort to exotic options. For example, consider a basket option where the underlying asset is the average between the FTSE 100 (main UK stock index) and the S&P 500 (main US index). This contract is well-suited for a company that has its investments equally split between the UK and US stock market. Other exotic options have an even more peculiar design (contract specification, payoff, etc.) so as to meet very particular hedging needs. What are the two most interesting examples you can think of? Describe the underlying risk that a firm wants to hedge and how the exotic option provides an efficient insurance against it.

Which of the following statements about European option contracts is TRUE? a. Typically American options are cheaper than otherwise similar European options due to the uncertainty regarding the date of exercise. b. One can synthesise a long forward position in the underlying by being long a call and short a put c. A long call position and a short put position both involve buying the underlying and so are equivalent d. The price of an option can be obtained by computing the true probabilities of each state of nature, working out the expected option payoff across those states and then discounting back to the present.

Imagine a situation where European options on some underlying stock have the following relationship. p+S > c+ K*exp(-rT). (a) Describe the arbitrage opportunities that are available with an example. (b) Now change those options to American-style options. Does the arbitrage strategy still work? Explain your answer.

1. According to the efficient market hypothesis (EMH), in a perfect market, the security prices reflect the true and fair value of all the underlying securities' assets at any time. On the contrary, an inefficient market is a market whose security price at any time does not entirely reflect the value of its assets. In this form of market, traders can beat the market because they can employ strategies like arbitrage and speculation. Explain with example, the price reactions towards the bad news that indicate market is inefficient.

Which of the following statements is correct?     As the volatility of the stock price increases (all else remaining unchanged), both European calls and puts become less valuable.     The seller of an option can choose whether to post a margin or not.     Consider a call and a put which are both written on the same asset, and have the same strike price and the same time-to-maturity. It is possible for the call and the put to be out-of-the-money at the same time.     The intrinsic value of a European option is the value it would have if the time-to-maturity was zero. Please explain and justify your choice using your own words.

I asked the question below earlier today, and got a response, but I didn't understand it.  I'm sure the response was well written and clear, but I have a very limited background in this area and probably need more of a layman's terms explanation!  Thanks. Suppose that C is the price of a European call option to purchase a security whose present price is S.  Show that if C>S then there is an opportunity for arbitrage (ie. riskless profit).  Assume the interest rate r=0 so present value calculations are unnecessary.

The binomial and Black-Scholes pricing models are the "guide posts" for pricing American and European options. Investors often consider employing stock options in their portfolios to minimize risk. They are viewed as "insurance" against losses in the portfolio. What are the pros and cons of the two models when pricing options? How would you incorporate the two models in your investment strategies/plans?

Organized exchanges offer important advantages like (a) mitigating credit risk and (b) providing liquidity. But they have the following market imperfections: 1. Open interest in futures contracts declines for longer maturities; so, for liquidity reasons, you may be unable to hedge longer deliveries using longer maturity futures contracts. Explain briefly how you would overcome these market imperfections.

Which is correct about security valuation? A. In an efficient market, several factors would affect the market and value is not necessarily equals the price. B. The value of the security is determined to compare it with the current market price and usually investor would buy when the value equals the price. C. Sellers would prefer the accept lower bid price than higher bid price to realize gains. D. Investors buy securities when securities are underpriced and sell them when it is overpriced. E. All of the above F. None of the above

My question is for a synthetic call option why do we need to borrow the present value of the strike price and what does it mean in a simple language explanation. Similarly why do we need to lend the present value of the stock at risk-free rate and what does it mean in simple language explanation?  Please also clarify the significance of risk free rate? Why is it used in put call parity.   Synthetic Call Option: If an investor believes that a call option is over-priced, then he/she can sell the call on the market and replicate a synthetic call. Borrow the present value of the strike price at the risk free rate and purchase the underlying stock and a put. Synthetic Put Option: Similar to the synthetic call option. A synthetic put can be created by re-arranging the put-call parity relationship, if the trader believes the put is overvalued. Synthetic Stock: A synthetic stock can also be created by rearranging the put-call parity identity. In this case, the investor will buy the…