Finance 2: Investors and Markets The theme for today Wed. May 20, 2009: Options, structured products; Sharpe’s Ch. 7 – except Sec But first a remark to Case 16 in Ch. 6: Hmmm … that’s weird! Added later: The explanation may be the way that order are executed. If supply does not match demand, the traded quantity (= min. (sum demand, suppy) ) is split between the ”excess side” proportionally to order size. So if you happen to be too bullish because bad probability estimates, it may bring you closer to the true optimum. Suppose 1 is offered for sale, and the the ”truely optimal” demand for each of two sellers is 1 unit. If you put in an order of 1, you get ½, but if you order 3, you get 0.75 units. It is – though – just a conjecture I have not investigated further.

Previously (i.e. in earlier courses) option pricing has been done in complete models. Allowing for dynamic trading, this is a fairly rich class of models. Arguably, this is somewhat of a moot point. Options are redundant; that is exactly why we can value them unambiguously.

With APSIM, we perform economically meaningful valuation in incomplete models. We find both buyers and sellers. It is only a 1-period framework, but that ce tweaked.

Financial innovation that adds welfare. (Not particularly comme il faut these days.) But always remember: Market efficiency. No free lunches. If something look good, it’s probably expensive. Non-linear instruments well suited for insurance and speculation. (Which is which depends on who’s looking.)

Examples of option structures Sec. 7.2: PIP or cliquet option. Sec. 7.8: m-shares, super-funds or Travoltas. (Easy to construct.) Sec. 7.4: Basic calls and puts. Always remember the put/call-parity: Call-Put = Underlying – discounted strike. (C – P = S – B * K)

Case : Quade and Dagmar trade options How are portfolios affected? (A lot.) How well are eq’ prices of options predicted from averages of agents’ res’ prices for state claims? (Very well.) What are the welfare gains (increases in expected utility) of introducing puts and calls? (Depends on the trading mechanism. Throw all in at once or add to equlibrium?) Is the call really redundant when put is traded? (The answer may surprise you.)