Please read the instructions below before the exam starts, and listen carefully to any instructions given by the invigilators. You may read the question paper before the exam starts but you must not write anything until the invigilator says that you may start. You will be given five minutes after the exam has finished to complete the front of any answer books used.
1 Answer Book
Only certified non-programmable calculators are permitted
UNIVERSITY OF READING
Derivative Securities: Pricing, Hedging and Trading
(ICM211)
Three hours
Answer any THREE questions
Q1 Explain the difference between trading actual underlying volatility
and implied volatility. Your answer should include diagrams and
detailed explanations of the different risk exposures. (100%)
Q2 a) Explain how it is possible that a long butterfly spread which
should be short Gamma, short Vega and long Theta, could have the
opposite Greek exposures (25%)
b) Explain why it is the case that the Vega and Theta exposure of a
long time spread are both long. (25%)
c) Explain how it is possible to make money when dynamically rehedging a short gamma position. (25%)
d) Is it true that if you buy a call and sell put with the same strike you
have created the ideal long Delta, long Vega position? Explain your
answer. (25%)
Q3 a) Explain how it is possible (and why you would do so) to create a
put ratio backspread from a call ratio backspread by adding two
more options positions. Explain the risks of each position. (25%)
b) Explain how you would create a long butterfly spread by adding a
call bear spread to a call bull spread. Explain the risks of this
position. (25%)
c) Explain how you would create a split strike synthetic futures
contract from a call ratio backspread by doing two trades. Explain
the risks of each position. (25%)
d) Explain how you would create a long condor from a short
strangle. Explain the risks of each position. (25%)
Q4. For the following 5 volatility spreads explain in detail and using
diagrams why and how the Greek exposures change as the
underlying price moves through the different strike prices, and the
effect the Greeks will have on the overall profitability of the position
at those different strikes.
a) Put ratio backspread (20%)
b) Call ratio vertical spread (20%)
c) Call ratio backspread (20%)
d) Short butterfly spread (20%)
e) Long butterfly spread (20%).
Q5. a) In what critical way does a put ratio backspread differ from
holding just long puts? Explain exactly why this is the case. (25%)
b) What is pin risk and what is the best way to manage it? (25%)
c) Are short butterflies always long Gamma, long Vega and short
Theta? Explain why this might not be the case. (25%)
d) Is it always the case that you will lock in a loss if you keep a long
Gamma position Delta neutral? (25%)
Q6. a) Outline the benefits and risks of holding a short time spread,
explaining why the Greek exposures are what they are. (25%)
(b) Explain how and why Theta changes through time. (25%)
(c) Why is the Gamma of deep ITM and deep OTM options zero, or
approaching zero ? (25%)
(d) Why is Theta referred to as “the price of Gamma”? (25%)
(End of Question Paper)
