Option

markets continued Futures week 10 & 11

Long Straddle going long on a call and put Profit long position spot price – Future (original settlement price)
𝑆" ≤ 𝑋 𝑆" > 𝑋 Profit short position Future (original settlement price) – spot price
Payoff call 0 𝑆"
+Payoff of put +(X-𝑆" ) +0
Total X-𝑆" 𝑆" − 𝑥
Short straddle is the opposite
Bullish spread two or more call or two or more put options on the same stock.
𝑆" ≤ 𝑋) 𝑋) < 𝑆" ≤ 𝑋+ 𝑆" > 𝑋+
Payoff first call exercise price 0 𝑆" − 𝑋) 𝑆" − 𝑋)
- payoff second call exercise price -0 -0 -(𝑆" − 𝑋+ )
Total 0 𝑆" − 𝑋) 𝑋+ − 𝑋)
Call option values

Variable Value Value of

Increases of call put

stock (S) + -

exercise (X) - +

SD stock + +
Time to exp + +/uncert
Interest rate + -
Dividend r - +

Hedge ratio=price change of call for 1 cent
change in stock price.
Apply Black Schole for C then use put call to find P, arbitrage strategy (RF profit)
𝑆" ≤ 𝑋 𝑆" > 𝑋
Pay off on call held 0 𝑆" − 𝑥
Payoff on put written -(x-𝑆" ) 0
Total 𝑆" − 𝑥 𝑆" − 𝑥

Market Efficiency Week 11 & 12

Random walk – stock price changes are unpredictable
efficient market hypothesis – price of securities fully reflect available information
about the securities
Competition among analysts creates efficiency
Weak form EMH – Market data available; historical data analysis is useless
Semi strong form – Prices already fully reflected, all public stock info available;
fundamental analysis is fruitless
Strong form – Price reflects all public and private info; No one can make abnormal
profit.
Magnitude issue, against market fluctuations a small increase in performance would
be hard to detect
Selection bias – investors will choose not to share arbitrage strategy’s
Lucky event issue – a successful strategy arises.
Momentum effect- poorly performing and well performing stocks to continue
performing
Over long horizons positive returns will eventually trend to be followed by negative

Performance Evaluation Week 7
The portfolio represents the investor’s entire risky investment fund
Sharpe ratio – ratio of excess return to standard deviation (total risk), slope of CAL
M square measure – differential return relative to benchmark index, understandable
sharpe
Portfolio is one of many combined into a large investment fund
Treynor’s measure – ratio of excess return to beta (systematic risk)
Jensen’s alpha – average return on the portfolio over and above return predicted by
CAPM, given the portfolio’s beta and the average market return
Useful when adding a portfolio to a diversified portfolio
Information ratio – divides alpha by non-systematic risk. Measures abnormal return
per unit of diversifiable risk.
Style analysis is a determinant of return for actively managed portfolios
Morning star risk adjusted ratings
Market Timing strategy that moves funds between risky portfolio and cash based on
forecast or relative performance
Portfolio Theories Week 5&6 Bond Markets Week 8&9
Efficiency frontier of risky assets graphically represents the set of Callable bond – May be repurchased by issuer at specified call price during call period
portfolios that maximise return for given standard deviations. Puttable bonds – Holder may choose to extend or for given years or exchange for par value
Floating Rate Bonds – Coupon rate changes due to market conditions
Convertible bonds – can be exchanged for shares.
Bond price can only use shortcut when there is a fixed coupon
𝐷𝑎𝑦𝑠 𝑠𝑖𝑛𝑐𝑒 𝑙𝑎𝑠𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 =
𝐷𝑎𝑦𝑠 𝑠𝑒𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
Bond price calculator
n = periods, I = interest (as a whole number 6%=6), PV is a present value (negative), FV=face value
of bond. PMT = Coupon
Discount Bond: coupon yield<current yield<YTM
Premium Bond: Coupon Yield>Current Yield>YTM
Bond at Par: Coupon Yield=current yield=YTM
𝛽 + ×𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛 equals systematic risk (undiversifiable
risk) Yield to call maturity is first call date so N=from issue to first call date FV is call price.
Sharpe ratio: risk premium: standard deviation Realised Coupon Yield is the actual coupon yield over entire investment assuming all coupons are
Expected return is always a weighted average re invested.
ABC(D,E) Go long when interest rates increase vice versa
Correlation coefficient 𝑐𝑜𝑟𝑟(𝑥, 𝑦) = 𝑝𝑥𝑦 = , −1 ≤ 𝑝𝑥𝑦 ≤ 1 interest rate yields increase; bond price falls.
FDFE
Negative correlation means assets moving in opposite direction so less risk Increase in YTM has less price change than an equal decrease of yield.
and better diversification benefits. Long term bond price more sensitive to interest rate change.
Variance matrix Low coupon bond price more sensitive to change in interest rates
Variance terms along diagonal Duration: weighted average maturity of bonds cash flows. measure of bonds price sensitivity.
CAPM – assumes investors are rational, no taxes, no transaction costs, all Modified duration direct measure of bond price sensitivity to yield change
risky assets are publically traded, any amount can be borrowing or lent at Zero coupon bond duration = maturity
risk free rate. higher coupon rate and/or YTM = shorter duration
Makowitz model left figure, generate efficient portfolios Can use swaps in active bond management
CML = Highest Sharpe ratio uses standard deviation as x axis substitution, inter-market, rate anticipation, pure yield
SML = risk premium as a function of systematic risk beta is x axis Term structure theories upward and downward slopes explained
Assets with negative beta offer better diversification as when market Expectation theory up: long term bond high yields as short term rates expected to increase down:
drops they benefit. future expected rates slower than current short spot rate
ej is firm specific risk aj is excess return, if CAPM correct 𝛼 is always 0 Liquidity preference: up: liquidity preference Down: future spot rate low offsets pref
COV between security I and j under a single index model leave Market segmentation: up: Excess supply of long term bonds Downward: excess supply of short
𝜎 𝑎𝑠 𝑎 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑑𝑜𝑛 M 𝑡𝑡𝑢𝑟𝑛 𝑖𝑡 𝑖𝑛𝑡𝑜 𝑎 𝑑𝑒𝑐𝑖𝑚𝑎𝑙. term Hump: Excess supply over demand for intermediate term maturities
risk premiums use simultaneous equations of E[R]=Rf+x1+x2 𝑠𝑝𝑜𝑡𝑟𝑎𝑡𝑒2+
𝐹𝑜𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 = 1𝑓2 = − 1
𝑆𝑝𝑜𝑡𝑟𝑎𝑡𝑒 1
WY)(Z[\\]^]_A] `]"a]]_ bcB"^d"]b)
𝑠𝑝𝑜𝑡𝑟𝑎𝑡𝑒4W
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝐹𝑜𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 = 1𝑓4 = V X − 1
Option Markets Week 9&10 𝑆𝑝𝑜𝑡𝑟𝑎𝑡𝑒 1
Long – investor believes prices will increase over time
Short – investor believes prices will decrease over time
Call option – contract that gives the holder the right but not obligation to buy
Payoff and profit graphs – x=stock price y=profit or loss
an underlying asset at a specified price before expiration.
Put option is the obligation to sell, they receive a premium at T=0
European option can only be exercised at the expiration date
American option can be exercised at or before the expiration date.
Leverage of options, much small investment required to establish position,
facilitates speculation. Hedging allows buyer’s maximum risk to be known in
advance and allows investors to manage risk without purchasing or selling
assets.

Payoff & profit to call option at exp 0 𝑖𝑓 𝑆" ≥ 𝑋
𝑃𝑢𝑡 ℎ𝑜𝑙𝑑𝑒𝑟 f
𝑆" − 𝑋 𝑖𝑓 𝑆" > 𝑋 𝑋 − 𝑆" 𝑖𝑓 𝑆" < 𝑋
𝑐𝑎𝑙𝑙 ℎ𝑜𝑙𝑑𝑒𝑟 f


0 𝑖𝑓 𝑆" ≤ 𝑋
−(𝑆" − 𝑋) 𝑖𝑓 𝑆" > 𝑋

𝑐𝑎𝑙𝑙 𝑤𝑟𝑖𝑡𝑒𝑟 f
0 𝑖𝑓 𝑆" ≤ 𝑋

Interest can be viewed as the risk free rate so in option stock strategy
questions use the t bill rate as the interest rate. Then form a table with
different possible stock prices.
Pay off of stock always = 𝑆"
Protective put long put plus stock, invest in stock and purchase put option on
the stock, guaranteed to pay off at least = to put option exercise price
payoff:
𝑆" ≤ 𝑋 𝑆" > 𝑋
Stock 𝑆" 𝑆"
Put X-𝑆" 0
Total X 𝑆"
Cover call is a stock plus short call, it is a purchase of a stock covered by the
sale of a call option on that stock, creates a maximum profit payoff:
𝑆" ≤ 𝑋 𝑆" > 𝑋
Pay off stock 𝑆" 𝑆"
- Payoff call -0 -(𝑆" − 𝑥)
Total 𝑆" X