DERIVATIVES MODULE 75

Question 1

75.1 What does firm value =

Answer 1

Firm value = Equity + PV (Debt)

AND we assume that firms’ debt finance is a zero-coupon bond

Question 2

75.1 Owning equity is equivalent to ….

Answer 2

A long call on the firm’s assets

Question 3

75.1 In the firm analogy, owning debt is equivalent to…

Answer 3

Writing a put option on company’s assets

Either are risk free - they get the value of their debt

OR they get the value of the firm, which could be lower than the PV of their debt

And the capturing of that downside is via a short put option on company assets

Question 4

75.1 what is the hedge ratio equation?

What is it used for?

Answer 4

It is used to compute the units of stock per short call to create a risk free portfolio

numerator = change in call
denominator = change in stock

Question 5

75.1 How do we verify the hedge ratio?

Answer 5

Make sure that it makes each scenario have the same outcome

Question 6

75.1 Using a binomial model, describe the stages required to value a derivative:

Answer 6

1. use the binomial model to see payoffs of the range of the min and max of outcomes for the stock price
2. Then calculate the payoff from the derivative in each case
3. find the hedge ratio
4. To compute the value of the derivative, use the risk free value, and discount it back by the risk free rate

Question 7

75.1 For a put option, the hedge ratio is always going to be…

Answer 7

NEGATIVE

because this will show you the units of long stock per SHORT PUT

BUT - we can make this into the units of long stock per LONG put by removing the negative signs

Question 8

75.1 What is risk-neutral pricing?

Answer 8

Question 9

75.1 With risk-neutral pricing in mind, what is the formula for the option value (premium)

Answer 9