Lectures Notes Finance first semester, Study notes of Economics

Download Lectures Notes Finance first semester and more Study notes Economics in PDF only on Docsity! Financial Options • Risk-return trade off for individual stocks: the CAPM Unsystematic risk is averaged out. The market only rewards for systematic risk → because it is the only risk that cannot be avoided. CML cannot describe the relation between expected returns and standard deviations for individual stocks. Instead of looking at correlations in stocks in portfolios look at how they move along with the whole stock market. These co-movements cannot be diversified away by definition. Global factors = market portfolio M. CAPM: reward investors for systematic risk that arises from comoving with the market. B reflects the sensitivity of individual returns to changes in the market index M (linear relation SD and E[R]. More general model than MPT because it holds for both individual stocks and portfolios. B=0 → E[R] = Rf B=1 → E[R] = E[Rm] B>1 → risky stocks B<0 → bonds, gold, safety assets, weapon industry CAPM describes a linear risk-return trade off for individual risky securities. B is a measure of systematic risk for individual risky securities. Security Market Line (SML) looks like CML but uses B on x-axis instead of SD. The line through Rf and M separates the area in two parts. Above part is stock with increased demand, below part is stock with increased supply. • Derivative instruments: financial options Risky asset whose value is ‘derived’ from the value of an underlying asset (stock, bond, exchange etc.) Their value (option premium) is a nonlinear function of the price of the underlying asset Types: options, forwards, futures, debt obligations ‘Financial’ innovations often exhibit similar features: you can earn lots of money with them, but they are also very risky Financial option is a contract that gives its owner the right to purchase/sell an asset at a current, fixed price (exercise or strike price) at some future date. Holder/owner has no obligation to exercise. Writer (seller): counterparty has the obligation to buy/sell the underlying asset when the option holder exercises the right Options also have an expiration (maturity) date and (remaining) time to maturity. There are Call and Put options and European vs. American options. European: right to buy a stock at an exercise price K on a specific future time point T (the expiration date) American: right to buy and exercise price K on or before the expiration date T Writer of the Call option has the obligation to sell the stock to the option holder whenever the latter would decide to exercise option. At maturity (expiration) the value is either zero (you do not exercise) or a positive value → the expiration value Writing a call: selling the option Buying a call: buying the option Speculate: when investors use contracts or securities to place a bet on the direction in which they believe the market is likely to move Speculating in stock market without options → buy a stock now in order to sell it in the future with a profit if you believe that the stock price will rise (not riskless!) Speculating with options → on stock price rises (calls, optimists) or falls (puts, pessimists), combination of options (hedge funds) Strangle: a portfolio that is long a call option and a put option on the same stock with the same exercise date but the strike price on the call exceeds the strike price on the put Reduce risk (hedging) → decrease cash flow uncertainty/bankruptcy risk by means of options to increase value of the firm St + Pt = X + Ct