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Investments , Wed. May 13, ’09

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.

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Investments , Wed. May 13, ’09

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  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.

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