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Lecture 10

Lecture

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12 views40 pages

Lecture 10

Lecture

Uploaded by

loydolagodamontanha
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Review APT, Efficient Markets

Hypothesis, Intro to Derivatives.

Lecture 10
Fama French Research

 Returns are related to factors other than market


returns
 Size
 Book value relative to market value
 Three factor model better describes returns
The Size Effect
from 1926 to 2003
Average Rate of Return
as a Function of Book to Market
APT and CAPM Compared

 APT applies to well diversified portfolios and not


necessarily to individual stocks
 With APT it is possible for some individual stocks to be
mispriced - not lie on the SML
 APT is more general in that it gets to an expected
return and beta relationship without the assumption of
the market portfolio
 APT can be extended to multifactor models
APT Proof (no idiosyncratic risk)

Supposethat there are n assets whose rates of return


are governed by K<n factors according to the equation
k
ri  ai   bij f j for i  1,..., n
j 1

Then there are constants 0 , 1 ,..., K such that :


k
ri  0   bij  j for i  1,..., n
j 1

Strategy of proof:
 First we construct zero beta portfolios and argue by
arbitrage.
 Next we use linear algebra and argue by
contradiction.
APT Proof (no idiosyncratic risk)
Choose  such that   k  0 for k  1, 2..., K and  1  0
This portfolio has zero cost and zero risk .
By No Arbitrage   ri  0
k
Suppose ri  0   bij  j for some i  1,..., n
j 1

Let l j j  1,..., K be the best linear fit of r onto 1, b j 


k
r  l01   bij l j  ei
j 1

Choosing l optimaly implies:


e1  0 and eb j  0 for j  1,..., K
Nowlet e be the weights of a costless and riskless portfolio with return :
k
er  ea   ebij  f j
j 1
k
er  e1l0   ebij  l j  ee  ee  0 !!! An arbitrage oportunity !!!
j 1
Efficient Market Hypothesis
(EMH)

 Do security prices reflect information ?


Random Walk and the EMH

 Random Walk - stock prices are random


– Actually submartingale
 Expected price is positive over time
 Positive trend and random about the trend

Security
Prices

Time
Random Price Changes

 Why are price changes random?


– Prices react to information
– Flow of information is random
– Therefore, price changes are random
EMH and Competition

 Stock prices fully and accurately reflect publicly


available information
 Once information becomes available, market
participants analyze it
 Competition assures prices reflect information
Cumulative Abnormal Returns
Surrounding Takeover Attempts
Returns Following
Earnings Announcements
Forms of the EMH

 Weak. All past price data in prices.


 Semi-strong. All public data in prices.
 Strong. All public plus insider information in
prices.
Derivative Securities Intro
 Readings:
– Chapters 14 15 & 16 in BKM
– Suggested further reading: Options, Futures and
other Derivatives by Hull.
 Why are they called derivatives?
 Options and Futures.
 Why are they useful?
 Are they dangerous?
– See Warren Buffet’s view.
 Note: in 1973 Chicago was the first place
were standard options were traded in a
national exchange.
Options

Lecture 11
Option Terminology

 Buy - Long
 Sell - Short
 Call
 Put
 Key Elements
– Exercise or Strike Price
– Premium or Price
– Maturity or Expiration
Market and Exercise
Price Relationships
In the Money - exercise of the option would be
profitable
Call: market price>exercise price
Put: exercise price>market price
Out of the Money - exercise of the option would not
be profitable
Call: market price<exercise price
Put: exercise price<market price
At the Money - exercise price and asset price are
equal
American vs European
Options
American - the option can be exercised at
any time before expiration or maturity

European - the option can only be exercised


on the expiration or maturity date
Different Types of Options

 Stock Options
 Index Options
 Futures Options
 Foreign Currency Options
 Interest Rate Options
Payoffs and Profits on Options
at Expiration - Calls

Notation
Stock Price = ST Exercise Price = X
Payoff to Call Holder
(ST - X) if ST >X
0 if ST < X
Profit to Call Holder
Payoff - Purchase Price
Payoffs and Profits on
Options at Expiration - Calls

Payoff to Call Writer


- (ST - X) if ST >X
0 if ST < X
Profit to Call Writer
Payoff + Premium
Payoff and Profit
to Call at Expiration
Payoff and Profit to
Call Writers at Expiration
Payoffs and Profits at
Expiration - Puts

Payoffs to Put Holder


0 if ST > X
(X - ST) if ST < X

Profit to Put Holder


Payoff - Premium
Payoffs and Profits at
Expiration - Puts

Payoffs to Put Writer


0 if ST > X
-(X - ST) if ST < X

Profits to Put Writer


Payoff + Premium
Payoff and Profit to
Put Option at Expiration
Calls are a levered position
Option Strategies

Protective Put Covered Call


Long Stock Long Stock
Long Put Short Call
Straddle Bullish Spread
Long Call Long Call Low Ex.
Long Put Short Call High Ex.
Value of Protective
Put Position at Maturity
Protective Put Versus
Stock Investment (at-the-money put)
Value of a Covered
Call Position at Expiration
Payoff to a Straddle
Payoff to a Bullish Spread
Optionlike Securities

 Callable Bonds
 Convertible Securities
 Warrants

 Collateralized Loans
– Housing
 Levered Equity and Risky Debt
– Incentive Problems (gamble debtors money)
Value of Callable Bonds
Compared with Straight Bonds
Value of a Convertible Bond
as a Function of Stock Price

The bond holder has the option to


exchange the bond for a predetermined
number of shares.
Collateralized Loan / Risky Debt
Levered Equity as a Call on
the Assets

Conflict of interest between bondholders and equity holders!!


Exotic Options

 Asian Options (Payoff depends on average not final price of


the underlying asset)
 Barrier Options
 Lookback Options (The payoff depends on the path typical max
or min price)

 Currency-Translated Options
 Binary Options (Arrow Debreu Securities)

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