UA FIN 421 - Chapter 15: Options Markets

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Chapter 15: Options MarketsCall option-right to buy an asset at a specified exercise price on or before a specified expiration dateStock Price>Exercise Price on Expiration date, value of the call option will equal the difference between the stock price and exercise pricePremium-purchase price of an option, represents the compensation the purchaser of the call must pay for the ability to exercise the option only when exercise is profitable.Put option- the right to sell an asset at a specified exercise price on or before a specified expiration date In the money-an option where exercise would generate positive cash flowOut of the money- option which, if exercise, would produce a negative cash flow. Out-of-the-money options are therefore never exercisedAt the money- an option where the exercise price equals asset priceOver the counter (OTC) markets advantages:- Terms of the option contract (exercise price, expiration date, & number of shares committed) can be tailored to the need of the tradersPut options are worth more when the exercise price is higherAmerican option-Can be exercised on or before its expirationEuropean option-can be exercised only at expirationIndex option-call or put based on a stock market index such as the S&P 500Futures options-give their holders the right to buy or sell a specified future contract,using as a futures price the exercise price of the optionForeign currency options- currency option offers the right to buy or sell a quantity of foreign currency for a specified amount of domestic currencyInterest rate options-options also are traded on Treasury notes & bonds, T-bills, & gov’t bonds of other major economies such as the U.K. or JapanCall optionsPayoff to call holder at expiration= St-X if St>X0 if St XSt=value of the stock at expiration date & X =exercise pricePayoff to call writer= -(St-X) if St> X0 if St XProtective put- asset combined with a put option that guarantees minimum proceeds equal to the puts exercise priceCovered call-writing a call on an asset together with buying the assetStraddle-a combination of a call and a put, each with the same exercise price and expiration dateSpread- a combination of 2 or more call options or put options on the same asset with differing exercise price or times to expirationCollar- an options strategy that brackets the value of a portfolio between two boundsChapter 16: Option ValuationIntrinsic value (IV)- stock price minus exercise price, or the cash flow that could be attained by immediate exercise of an in-the-money call optionTime value (TV)- difference between an option’s price and its intrinsic P= IV + TV6 Factors that affect the value of a call option: Stock price, exercise price, volatility ofthe stock price, time to expiration interest rate, & dividend rate of the stockStock price increases, call option increasesExercise price increases, call option decreasesVolatility increases, call option increasesTime to expiration increases, call option increasesInterest rate increases, call option increasesDividend payouts increases, call option increasesStock price increases, put option decreasesExercise price increases, put option increasesVolatility increases, put option increasesTime to expiration increases, put option increases/uncertainRf increases, put option decreasesDividend payout increases, put option increasesBinomial model-option valuation model predicated on the assumption that stock prices can move to only two values over any short time periodBlack-Scholes Pricing Formula- a formula to value an option that uses the stock price, the risk-free interest rate, the time to expiration, and the standard deviation of the stock returnImplied volatility- standard deviation of stock returns is consistent with an options market valuePut-call parity relationship- an equation representing the proper relationship between put & call pricesHedge ratios- number of shares of stock required to hedge the price risk of holding one optionOption elasticity- percentage increase in an options value given a 1% increase in the value of the underlying securityPortfolio insurance- portfolio strategies that limit investment losses while maintaining upside potential Dynamic hedging-constant updating of hedge positions as market conditions changeChapter 18: Portfolio Performance EvaluationPassive management- holding a well-diversified portfolio without attempting to search out security mispricingCash-shorthand for virtually risk-free money market securitiesActive management- attempts to achieve returns higher than commensurate with risk by forecasting broad markets and/or by identifying mispriced securitiesComparison universe- set of portfolio managers with similar investments styles thatis used to assess relative performance Shape ratio- reward-to-volatility ratio; ratio of portfolio excess return to standard deviationS= R-bar/ Standard DeviationR-bar= average return- average risk free rateM-square- return difference between a managed portfolio leveraged to match the volatility of a passive index and the return on that indexFund of funds- mutual funds or hedge funds that invest in other fundsTreynor measure- ratio of portfolio excess return to beta, T= R-bar/ BetaInformation ratio- ratio of alpha to the standard deviation of diversifiable risk Info ratio= Alpha/ Residual Standard DeviationJensen measure- alpha of an investment -A negative, or short position in a negative alpha stock will turn the alpha positive-If the stocks beta is positive, a negative position in it will also reduce systematic and therefore overall riskAlpha capture- construction of a positive-alpha portfolio with all systematic risk hedged awayAlpha transfer or alpha transport- establishing alpha while using index products both to hedge market exposure & to establish exposure to desired sectorsSurvivorship bias- upward bias in average fund performance due to the failure to account for failure to account for failed funds over the sample periodBogey- benchmark portfolio an investment manager is compared to for performance evaluationMarket timing- a strategy that moves Ch. 15-Self-test Ch.15 Problem Sets: 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 16, 17, 18, 22, 23, 24, 25, 26, 27, 28-Self-test Ch. 15 CFA Problems: 1, 2, 3, Ch. 16-Self-test Ch.16 Problem Sets: 1, 2, 3, 4, 5, 6, 7, 8, 9, 16, 17, 18, 21, 22, 23, 27, 29, 32, 38, Ch. 18-Self-test Ch.18 Problem Sets: 1, 2, 3, 4, 5, 7, 10, 16, Ch. 19-Self-test Ch.19 Problem Sets: 1,2, 3, 5, 6, -Self-test

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UA FIN 421 - Chapter 15: Options Markets

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