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MCQ-Delta Hedging

The document contains 5 multiple choice questions about valuing American options using binomial trees and risk-neutral valuation. Question 1 asks which nodes require checking for early exercise of an American option in a binomial tree, to which the answer is A - at all nodes where the option is in-the-money. Question 2 and 3 ask about the expected return on the stock and option in a risk-neutral binomial tree, to which the answer is C - the risk-free rate. Question 4 asks about the correct discount rate to use in the real world, to which the answer is D - it could be more or less than the stock's expected return. Question 5 asks about how a call option price is affected by the stock's

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117 views2 pages

MCQ-Delta Hedging

The document contains 5 multiple choice questions about valuing American options using binomial trees and risk-neutral valuation. Question 1 asks which nodes require checking for early exercise of an American option in a binomial tree, to which the answer is A - at all nodes where the option is in-the-money. Question 2 and 3 ask about the expected return on the stock and option in a risk-neutral binomial tree, to which the answer is C - the risk-free rate. Question 4 asks about the correct discount rate to use in the real world, to which the answer is D - it could be more or less than the stock's expected return. Question 5 asks about how a call option price is affected by the stock's

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keshav
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1. Which of the following describes how American options can be valued using a binomial tree?

A. Check whether early exercise is optimal at all nodes where the option is in-the-
money
B. Check whether early exercise is optimal at the final nodes
C. Check whether early exercise is optimal at the penultimate nodes and the final
nodes
D. None of the above

Answer: A

For an American option we must check whether exercising is better than not exercising
at each node where the option is in the money. (It is clearly not worth exercising when
the option is out of the money)

2. In a binomial tree created to value an option on a stock, the expected return on stock is
A. Zero
B. The return required by the market
C. The risk-free rate
D. It is impossible to know without more information

Answer: C

The expected return on the stock on the tree is the risk-free rate. This is an application
of risk-neutral valuation.

3. In a binomial tree created to value an option on a stock, what is the expected return on the
option?
A. Zero
B. The return required by the market
C. The risk-free rate
D. It is impossible to know without more information

Answer: C

The expected return on the option on the tree is the risk-free rate. This is an application
of risk-neutral valuation. The expected return on all assets in a risk-neutral world is the
risk-free rate.

4. A stock is expected to return 10% when the risk-free rate is 4%. What is the correct discount
rate to use for the expected payoff on an option in the real world?
A. 4%
B. 10%
C. More than 10%
D. It could be more or less than 10%

Answer: D

The correct answer is D. There is no easy way of determining the correct discount rate
for an option’s expected payoff in the real world. For a call option the correct discount
rate in the real world is often quite high and for a put option it is often quite low (even
negative). The example in the text illustrates this.

5. Which of the following is true for a call option on a stock worth $50
A. As a stock’s expected return increases the price of the option increases
B. As a stock’s expected return increases the price of the option decreases
C. As a stock’s expected return increases the price of the option might increase or
decrease
D. As a stock’s expected return increases the price of the option on the stock stays the
same

Answer: D

The option price when expressed in terms of the underlying stock price is independent
of the return on the stock. To put this another way, everything relevant about the
expected return is incorporated in the stock price.

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