Economics 434 theory of financial markets
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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

Economics 434Theory of Financial Markets

Professor Edwin T Burton

Economics Department

The University of Virginia


Final exam tuesday december 13 2011

Final Exam…Tuesday, December 13, 2011


The no arbitrage principle

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


Three main types of derivatives

Three Main Types of Derivatives

  • Options

  • Futures (Forwards)

  • Swaps


Options

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


Common option terms

Common Option Terms

  • Exercise Price (or “strike” price)

  • Maturity (or “expiration” date)

  • Premium (or price)

  • Volatility (Variance of Stock Price)


Value at maturity

Value at Maturity

Jul 40 Calls

Expire 3rd Friday

Value

Worthless Below 40

Dollar for dollar

40

Price of the “Underlying” Stock


Economics 434 theory of financial markets

Value of Call Option at Expiration

The Jul 40 Call Option

20

0

40

60


Economics 434 theory of financial markets

Value of Jul 40 Put Option at Expiration

40

0

40

0


Economics 434 theory of financial markets

Value

If time to expiration increases

“Delta” at the strike is 1/2

Price of Stock


Delta

“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


Futures

Futures

  • Different Method of Paying

  • Delayed Settlement

  • Like buying a house


Two main types of futures depending upon settlement

Two Main Types of Futures(Depending Upon Settlement)

  • At maturity, futures owners get something

    • Either get actual commodity

    • Or, get “cash equivalent”


Settlement in the underlying

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


Imagine gold

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


Settlement in cash

Settlement in “cash”

  • S&P 500 Futures

  • Most Stock Index Futures


First what is the s p 500 future

First, What is the S&P 500 Future?

  • 500 Stocks

  • Weighted by Market Capitalization

  • Futures: Jun, Sep, Dec, Mch


Futures are marked to market

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


Final exam

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


The end

The End


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