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Category: 101 Concepts for Level I

Concept 90: Use of Arbitrage, Replication, and Risk Neutrality in Pricing Derivatives

Arbitrage is the condition under which two equivalent assets or derivatives or combination of assets and derivatives sell for different prices. This allows an arbitrageur to buy at a low price and sell at a high price, and earn a risk-free profit from this transaction without committing any capital. In well-functioning markets, arbitrage opportunities are quickly exploited. The combined actions of arbitrageurs force the prices of similar securities to converge. Hence, arbitrage leads to the law of one price: securities or derivatives that produce equivalent results must sell for equivalent prices. Replication is the creation of an asset or a… Read More

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Concept 91: Difference in Forward and Futures Prices

Futures prices can differ from forward prices because of the effect of interest rates on the interim cash flows from the daily settlement. If interest rates are constant, or have zero correlation with futures prices, then forwards and futures prices will be the same. If futures prices are negatively correlated with interest rates, then it is more desirable to buy forwards than futures. If future prices are positively correlated with interest rates, then it is more desirable to buy futures than forwards. If immediate exercise would result in loss, then the option is out of the money. If immediate exercise… Read More

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Concept 92: Exercise Value, Time Value, and Moneyness of an Option

Moneyness refers to whether an option is in the money or out of the money. If immediate exercise of the option would result in positive payoff, then option is in the money. If immediate exercise would result in loss, then the option is out of the money. If immediate exercise would result in neither a gain nor a loss, then the option is at the money.   Call Option Put Option In-the-money S > X S < X At-the-money S = X S = X Out-of-the-money S < X S > X Exercise value of an option is the maximum… Read More

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Concept 93: Factors that Determine the Value of an Option

Increase in Value of call option will Value of put option will value of the underlying Increase Decrease exercise price Decrease Increase risk-free rate Increase Decrease time to expiration Increase Increase (exception: a few European puts) volatility of the underlying Increase Increase costs incurred while holding the underlying Increase Decrease benefits received while holding the underlying Decrease Increase

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Concept 94: Put–Call Parity for European Options

European put and call prices are related through put–call parity, which specifies that the put price plus the price of the underlying equals the call price plus the present value of the exercise price. According to put-call parity, Fiduciary call = Protective put Assume call and put options with an exercise price of $100 in which the underlying is at $90 at time t=0. The risk free rate is 10% and the options expire in 3 months. The call price is $2. Calculate the put price. Solution:  

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Concept 95: Alternative Investments v/s Traditional Investments

Traditional investments include long-only position in stocks, bonds and cash. All other investments are classified as alternative investments. Alternative investments include investments in: real estate commodities private equity hedge funds Compared to traditional investments, alternative investments typically have: lower liquidity. less regulation. lower transparency. higher fees. limited and potentially biased historical risk and return data. unique legal and tax considerations.

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Concept 96: Types of Alternative Investments

Hedge funds Uses a partnership structure with a general partner who manages the fund and accepts unlimited liability and limited partners (investors) who own fractional interests in the partnership and have limited liability. The general partner typically receives a management fee based on assets under management and an incentive fee based on the performance of the fund. Hedge funds are typically classified by strategy into four broad categories: Event-driven: Includes merger arbitrage, distressed/restructuring, activist shareholder and special situation. Relative value: Strategies that seek to profit from pricing discrepancies. Macro: Strategies based on top-down analysis of global economic trends. Equity hedge:… Read More

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Concept 97: Hedge Fund Fees

The total fee for a hedge fund consists of a management fee and an incentive fee. Common fee structure is 2 and 20 which means 2% management fee and 20% incentive fee. Funds of funds charge an additional 1 and 10 fee (1% management fee and 10% incentive fee). Incentive fee is usually calculated on profits net of management fees or on profits before management fee. Sometimes, the incentive fee is paid only if the returns exceed a hurdle rate. In some cases the incentive fee is paid only if the fund has crossed the high watermark. High watermark is… Read More

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Concept 98: Framework for Ethical Decision Making

A framework for ethical decision making can help people look at and assess a decision from different perspectives. This enables them to make good decisions, and to limit unplanned consequences. A general ethical decision making framework has the following four steps: Identify: Relevant facts, stakeholders and duties owed, ethical principles, conflicts of interest. Consider: Situational influences, additional guidance, alternative actions. Decide and act. Reflect: Was the outcome as anticipated? Why or why not?

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Concept 99: Ethical Responsibilities Required by the Code and Standards

I. Professionalism A. Knowledge of the law Understand and comply with all applicable laws, rules and regulation. In a case of a conflict, comply with the stricter law. Do not knowingly participate in any violation. Disassociate from such activity. B. Independence and objectivity Use reasonable care and judgment. Maintain independence and objectivity. Do not offer, solicit or accept gifts; however, small token gifts are ok. C. Misrepresentation Do not guarantee investment performance. Avoid plagiarism (the practice of taking someone else’s work or ideas and passing them off as one’s own). Do not omit important facts. D. Misconduct Do not lie,… Read More

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