(Derivatives & Risk Management - Black-Sholes Option Pricing Model)
1. Discuss what is represented by the first and second terms of the B-S model. This should include the individual components of each term, what it represents, how it relates to the other terms, and how the two terms jointly reflect the equilibrium value of a call option.
2. Why is the variable important in the B-S model? How does relate to the expected range of values for the underlying (in both a qualitative and quantitative sense)
3. The instantaneous volatility of the B-S model: historical vs. implied
4. Explain how the delta (i.e., the N(d1) variable) can be used to estimate a hedge ratio and create a hedge position as part of a replicating portfolio. (Note that this refers to the B-S option pricing model.)
Extra:
-The replicating portfolio should be approximately delta neutral (i.e., the delta should be close to zero), but the value of the position changes as the price of the underlying moves away from the strike price. Explain why this is so, and discuss whether this has implications for options pricing models.