FINS2624 Lecture Notes - Lecture 6: Efficient-Market Hypothesis, Call Option, Noise Trader
EMH and behavioural finance
- market efficiency: all correctly taken into account information when forming
expectations- only NEW information can move the price (could not be inferred from
currently available information- random)
o means stock prices follow a random walk: $P ∆s random and independent of
history (new information moves stock P- P∆s idep of histoy
- Efficient Market Hypothesis (EMH): market prices reflect available information- weak
form, semi-strong form (reflects all public information), strong form (reflects all
available information- incl non public) (unidirectional relationship)
o Fast and correct incorporation of relevant information into $P → information
advantage
- Power of crowds: guessing the weight of the bull book
o Average guess:
- Technical analysis: using patterns in past stock $P/returns/trading to predict future
returns → violates weak EMH
- Fundamental analysis: publicly available data to understand fundamentals to make
superior valuations → violates semi-strong EMH
- Insider trading: non-public information → violates strong EMH
- Tests for EMH
o Hard to get sufficient statistical power since volatility of stock prices is large
compared to the presumed effects of individuals or strategies beating the
market
o Reporting bias (not all information published)
- Market prices may deviate from intrinsic values if: some investors behave in an
irrational manner (behavioural biases)
- Limits of arbitrage: execution risk, model risk, noise trader risk (expose arbitrageur
to carry costs and margin calls)
- Behavioural biases: heuristics
o Anchoring: use historical price as benchmark and adjust
o Disposition effect: unwilling to sell stocks that have depreciated in value but
keen to sell stocks that have increased in value since buying them (anchor
their valuation of the stock to the purchase price)
o Overconfidence and excessive trading (each trade is a zero-sum game)
o Under-diversification: overconfidence tends tb stronger when dealing w
familiar things, investors may be unduly sure about their predictions
oeig thei o outy ad opay hoe ias
o Darwinism
Lecture 10: Option Strategies
- Derivatives: depends on underlying asset (S)
- Time-of-maturity (T) (CF consequences)
- Options: derivatives that give the holder the right but not obligation to trade
underlying asset: call, put, strike/exercise price (X)
- Intrinsic value: value added by the option if exercised today
find more resources at oneclass.com
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o If current M $P of underlying asset S(t), is higher than X, the call option allows
the holder to buy underlying asset at discount (S(t)-X)
o If S(t) <= X, call option holder would rather buy the underlying asset at M $P
and ignore option ie intrinsic value is zero
o If current M $P of underlying asset S(t), is lower than X, the put option allows
the holder to sell the underlying asset at a higher price: X- “t is optio’s
intrinsic value
o If S(t) >= X, put option holder would rather sell the underlying asset at M $P
and ignore option ie intrinsic value is zero
▪ If intrinsic value >0 → in the money (call: X<S; put: X>S) vs. out of the
money → deep in/out of the money
▪ Strike $P= current M $P of underlying A ie X=S (at the money)
- Time value: value arising from possibility of price moving favourably for your option
o Comes mainly from possibility that the moneyness may increase in the future
→ Pr inc w time to maturity (time value increases w time to maturity) +
volatility of underlying asset $P (time value increases w underlying volatility)
- Total value of option = intrinsic value + time value
- European vs. American options
- Option premium
- Creating and selling option = writing/issuing option (short-selling)
- Settlement: physical (actual trade) vs. cash (pay out intrinsic value of option)
- Contract size
- Strategies:
o Hedging
o Speculation (undervalued buy call option/overvalued buy put option)
- Payoff f for call option: max(0,S-X)
- Payoff f for put option: max(0,X-S)
- Profit diagrams
find more resources at oneclass.com
find more resources at oneclass.com
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Power of crowds: guessing the weight of the bull book: average guess: Technical analysis: using patterns in past stock /returns/trading to predict future returns violates weak emh. Fundamental analysis: publicly available data to understand fundamentals to make superior valuations violates semi-strong emh. Insider trading: non-public information violates strong emh. Tests for emh: hard to get sufficient statistical power since volatility of stock prices is large compared to the presumed effects of individuals or strategies beating the market, reporting bias (not all information published) Market prices may deviate from intrinsic values if: some investors behave in an irrational manner (behavioural biases) Limits of arbitrage: execution risk, model risk, noise trader risk (expose arbitrageur to carry costs and margin calls) Options: derivatives that give the holder the right but not obligation to trade underlying asset: call, put, strike/exercise price (x) Intrinsic value: value added by the option if exercised today.
