Basics of Option Valuation
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Comm367
Intrinsic Value
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Intrinsic value is the value realized from
immediate exercise
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Call options: maximum (ST-X, 0)
Put options: maximum (X-ST, 0)
Prior to option maturity, option premiums
exceed intrinsic value
Time Val
Introduction to Options
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Comm367
Nature of Derivatives
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Value of the instrument depends on the values
of other more basic underlying variables
Example of derivatives
Forward Contract: calls for future delivery of an
asset at an agreed price.
Futures C
Dividend Discount Model (DDM)
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Cash flows from holding a share: dividends
+ share price when the share is sold.
If the share is held for 1 period,
D1 + P
1
P=
0
1 +k
According to the fundamental theory of valuation:
D1
D2
D3
P0 =
+
+
+ =
2
3
1 + k (1 + k
Managing Bond Portfolios
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COMM 367
Interest Rate Sensitivity
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Inverse relationship between price and yield
An increase in a bonds yield results in a smaller
price decline than the gain associated with a
decrease of equal magnitude in y
Bond Valuation and Term
Structure of Interest Rates
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COMM 367
Pricing of Coupon Bonds
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T
C
F
Bond Value = PV Coupons + PV Face Value
=
P
+
B
t =1
(1 + r ) t
(1 + r ) t
If the interest rate is constant,
where:
C = Coupon paid each period
r = Disc
Technical Analysis
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Technical Analysis
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An attempt to exploit recurring and
predictable patterns in stock prices
Technicians beliefs:
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Shifts in market fundamentals can be discerned
before their impact is fully reflected in prices
Market fund
Market Efficiency
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Comm367
COMM 367
Meanings of Market
Efficiency
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Market efficiency: prices fully and
instantaneously reflect all available relevant
information.
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Price changes are independent
Market efficiency S There is no free lunch
Risk/Return tra
Index Models and the
Arbitrage Pricing Theory
Objectives
To introduce the index model and the APT
To discuss & illustrate arbitrage
The Single Index Model
The Arbitrage Pricing Theory
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The Single Index Model
Advantages:
Reduces the number of inpu
The Capital Asset Pricing
Model
Click to edit Master subtitle style
1
Comm367
Capital Asset Pricing Model
(CAPM)
Equilibrium model that underlies all
modern financial theory
Derived using principles of
diversification with simplified
assumptions
Markowitz
Optimal Risky Portfolios
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Comm367
Chapter Summary
Objectives:
To examine portfolio risk
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Portfolio risk and diversification
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The two security portfolio
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Extending to n securities
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The role of correlation
The optimal portfolio
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The minimum variance f
Risk Aversion and Capital
Allocation to Risky Assets
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Comm367
The Utility Function
Choice between expected return and risk,
the latter measured by the variance or
standard deviation
Quadratic utility
U = E(r) - ()A2
U = utility
E ( r ) = expected return
Risk and Return: Analyzing
the Historical Record
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Comm367
Factors Influencing
Rates
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Supply
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Demand
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Households
Businesses
Governments Net Supply and/or
Demand
Central Bank Actions
2
Comm367
InterestRates
Supply
r
r
1
0
Comm367
Demand
Q0 Q
1
Funds
3
R
M ut ual Funds and t he
I nst it ut ional Envir onment
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Comm367
Institutional Investors
TypeofInvestor
RiskTolerance
Individualandpersonal
trusts
Lifecycle
Mutualfunds
Variable
Pensionfunds
Dependsonproximityof
payouts
Endowmentfunds
Generallyconservativ
Securities Markets (Part 1)
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Comm367
Importance of Financial
Markets (Review)
Help firms and governments raise cash
by selling securities
Channel funds from savers to
borrowers
Provide a place where investors can
act on their beliefs
Help allocate cash t
Financial Instruments
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Comm367
Summary of Financial
Instruments
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Non-marketable financial assets
Money market instruments
Fixed-income instruments
Equities
Derivative Securities
Options and Futures
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Comm367
Summary of Financial
Instruments
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Fo
Understanding Investments
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COMM 367
Investments
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In this class, we will study the process of
committing funds to one or more assets
Emphasis on holding financial assets and
marketable securities
Concepts also apply to real assets
Foreign financi