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Economics 434 Theory of Financial Markets

Economics 434 Theory of Financial Markets. Professor Edwin T Burton Economics Department The University of Virginia. Final Exam…Tuesday, December 13, 2011. The “No-Arbitrage” Principle. Does not require “equilibrium Means Cannot make something out of nothing

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Economics 434 Theory of Financial Markets

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  1. Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

  2. Final Exam…Tuesday, December 13, 2011

  3. The “No-Arbitrage” Principle • Does not require “equilibrium • Means • Cannot make something out of nothing • Cannot make an infinite amount out of a finite investment

  4. Three Main Types of Derivatives • Options • Futures (Forwards) • Swaps

  5. Options Definition Right to buy (sell) 100 shares of stock at a fixed price by a fixed date Option to buy is a “call” option Option to sell is a “put” option

  6. Common Option Terms • Exercise Price (or “strike” price) • Maturity (or “expiration” date) • Premium (or price) • Volatility (Variance of Stock Price)

  7. Value at Maturity Jul 40 Calls Expire 3rd Friday Value Worthless Below 40 Dollar for dollar 40 Price of the “Underlying” Stock

  8. Value of Call Option at Expiration The Jul 40 Call Option 20 0 40 60

  9. Value of Jul 40 Put Option at Expiration 40 0 40 0

  10. Value If time to expiration increases “Delta” at the strike is 1/2 Price of Stock

  11. “Delta” How much option price increases for 1 point increase in stock price Actually a “derivative” of the option price with respect to a change in the stock price

  12. Futures • Different Method of Paying • Delayed Settlement • Like buying a house

  13. Two Main Types of Futures(Depending Upon Settlement) • At maturity, futures owners get something • Either get actual commodity • Or, get “cash equivalent”

  14. Settlement (in the “underlying”) • You get • Cattle, Gold, Silver, Yen • Whatever (?) • Exact amount as specified in “contract” regardless of price • Pay the original price of the futures contract

  15. Imagine Gold • Imagine gold at $ 1600, with risk free rate at 5 % • 100 ounces in futures contract means $ 1600 times 100 ounces = $ 160,000 • If current gold price is $ 1600, what is the three month futures price • Carry cost is 5 % times $ 1600 times ¼ = $ 20.00 • Answer would be $ 1,620.00 • But, what about storage cost • If the future is $ 1626, then storage costs are $ 2.00 per three month, or $ 24 per year

  16. Settlement in “cash” • S&P 500 Futures • Most Stock Index Futures

  17. First, What is the S&P 500 Future? • 500 Stocks • Weighted by Market Capitalization • Futures: Jun, Sep, Dec, Mch

  18. Futures are “marked to market” • Every single day • If you can’t pay, they liquidate • No exceptions • Futures trade with limits • So, you can get locked into to an infinite loss

  19. Final Exam • Readings • Financial Market Theory, pp. 1-206 (which means not all of the Derivatives chapter…only up to but not including “treasury bond futures” • This Time is Different, Chapters 5, 13, 14 • Coverage • Fixed Income, MPT, Leverage, Options & Futures • All classes, powerpoint slides, readings

  20. The End

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