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Economics 434 Theory of Financial Markets

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Professor Edwin T Burton

Economics Department

The University of Virginia

- Does not require “equilibrium
- Means
- Cannot make something out of nothing
- Cannot make an infinite amount out of a finite investment

- Options
- Futures (Forwards)
- Swaps

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

- Exercise Price (or “strike” price)
- Maturity (or “expiration” date)
- Premium (or price)
- Volatility (Variance of Stock Price)

Jul 40 Calls

Expire 3rd Friday

Value

Worthless Below 40

Dollar for dollar

40

Price of the “Underlying” Stock

Value of Call Option at Expiration

The Jul 40 Call Option

20

0

40

60

Value of Jul 40 Put Option at Expiration

40

0

40

0

Value

If time to expiration increases

“Delta” at the strike is 1/2

Price of Stock

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

- Different Method of Paying
- Delayed Settlement
- Like buying a house

- At maturity, futures owners get something
- Either get actual commodity
- Or, get “cash equivalent”

- 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 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

- S&P 500 Futures
- Most Stock Index Futures

- 500 Stocks
- Weighted by Market Capitalization
- Futures: Jun, Sep, Dec, Mch

- 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

- 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