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Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 Economics 434 Theory of.

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Presentation on theme: "Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 Economics 434 Theory of."— Presentation transcript:

1 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 Economics 434 Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

2 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 Three Main Types of Derivatives Options Futures (Forwards) Swaps

3 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 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

4 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 Common Option Terms Exercise Price (or “strike” price) Maturity (or “expiration” date) Premium (or price) Volatility (Variance of Stock Price)

5 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 Value at Maturity Value Price of the “Underlying” Stock Jul 40 Calls Expire 3 rd Friday 40 Dollar for dollar Worthless Below 40

6 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 40 0 60 20 Value of Call Option at Expiration The Jul 40 Call Option

7 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 Value of Jul 40 Put Option at Expiration 40 0 0

8 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 If time to expiration increases Value Price of Stock “Hedge Ratio” or “Delta” at the strike is 1/2

9 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 “Delta” (“Hedge Ratio) 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

10 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 Put-Call Parity “Forward Conversion” (an arbitrage investment) Buy 100 shares of stock Buy one Jan 40 Call Sell one Jan 40 Put If you do nothing until the option expiration, result will be to sell 100 shares of stock and receive $ 4,000, regardless of the price of the stock “Reverse Conversion” (an arbitrage borrow transaction) Sell 200 shares of stock Sell one Jan 40 Call Buy one Jan 40 Put If you do nothing until the option expiration, result will be to buy 100 shares of stock and pay $ 4,000, regardless of the price of the stock

11 Economics 434 – Financial Market Theory Thursday, August 25, 2009 Thursday, August 24,Thursday, September 21, Tues, Nov 27, 2012 The End

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