Derivatives and Alternative Investments
Pricing Logic and Payoffs
Derivatives questions are built on no-arbitrage. A forward price equals the spot price compounded at the risk-free rate minus the future value of carry benefits, plus storage or carry costs. Option values depend on the underlying price, strike, volatility, time, rate, and income; put-call parity ties European calls and puts together, and violations imply arbitrage. Candidates must be able to construct payoff diagrams and explain how delta, gamma, theta, vega, and rho respond to market moves.
Alternatives
Hedge funds, private equity, real estate, and commodities require attention to return measurement and risk. Traps include using IRR for illiquid funds without recognizing its reinvestment assumption, ignoring survivorship and backfill bias in hedge fund indices, and treating smoothed appraisal values as if they were market prices. Know the fee structure (management plus incentive, with hurdle and high-water mark) and how it dilutes returns, and understand diversification benefits that are overstated when reported correlations are smoothed.
Worked Example
A stock trades at 100, the risk-free rate is 5%, and a one-year European call with strike 100 costs 8. Parity gives the put as call − spot + strike/(1.05) = 8 − 100 + 95.24 = 3.24. If the put trades at 2.50, buy the put, sell the call, and buy the stock to capture the arbitrage. Rule of thumb: parity is the fastest check on any European option price.