1. Essay question. Which of the variables affecting option pricing is not directly observable? If this variable is estimated to be higher or lower than the variable actually is, how is the option valuation affected?

2. Essay question. Discuss the differences in writing covered and naked calls. Are risks involved in the two strategies similar or different? Explain.

3. Consider the following strategy: sale of one call with the exercise price X1 = $75 for $6, sale of one call with the exercise price X2 = $80 for $4, buy of one call with the exercise price X3 = $70 for $9, and buy of one call with the exercise price X4 = $85 for $2.

Graph the profit diagram to this strategy.

What is the maximum profit of a trader?

What is the maximum loss?

What is the name of this strategy?

What is a trader betting on when he/she is employing such a strategy?

4. Calculate the values of call and put options on the following stock:

Time to maturity:                     3 months

Standard deviation:                 70% per year

Exercise price:                        $40

Stock price:                             $45

Interest rate:                            5%