1. Investments, Wed. May 13, ’09 The 3 part plan for today Options, structured products; Sharpe Ch. 7 – except Sec. 7.9. Remarks to Hand-In #2. There are some subtle points. Measuring people’s preferences; the distribution builder. Sharpe Sec. 7.9.

2. 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. (Albeit only in a 1-period framework.) We find both buyers and sellers.

3. 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. Pay-off structures are non-linear. Simple CAPM(‘ish) pricing may work poorly. Instruments well suited for insurance and speculation. (Which is which depends on who’s looking.)

4. 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)

5. Case 19 + 20: Quade and Dagmar trade options. What are the welfare gains (increases in expected utility) of introducing puts and calls? Is the call really redundant when put is traded? (The answer may surprise you.)

6. Case 21-23: Kinked preferences. Morale of the story: Hockey stick marginal utilities go well hockey stick pay-off functions. Section 7.11: Remarks that are profectic in hindsigt. Peso problem, LTCM collapse, financial crisis 2007+. Sell protection for states that bad – but not really bad.