Next Tuesday’s reading assignment for Finance 4366

Here’s the list of assigned readings for next Tuesday’s class meeting:

  1. Hull Chapter 13 (“Binomial Trees”)
  2. Binomial Option Pricing Model (single-period)
  3. Multiple Period Binomial Option Framework
  4. Dynamic Delta Hedging Numerical Example (calls and puts)
  5. Dynamic Replicating Portfolio Numerical Example (calls and puts)
  6. Convergence of the Cox-Ross-Rubinstein (CRR) Binomial Option and Black-Scholes-Merton (BSM) Option Pricing Formulas

The two most important readings for next Tuesday’s Finance 4366 quiz and class meeting are Hull’s “Binomial Trees” chapter and my teaching note entitled “Binomial Option Pricing Model (single-period)”.  Tuesday’s class meeting will be primarily devoted to covering the latter reading in particular, although the other readings are also quite important for the next few Finance 4366 class meetings.

Formula sheet for midterm 1 is now available

I just posted the formula sheet for the exam at http://fin4366.garven.com/spring2018/formulas_part1.pdf.

Regarding the exam, it consists of four problems, and you only have to complete three of the four problems. At your option, you may complete all four problems, in which case I will count the three highest scoring problems. Since the maximum number of points possible for three problems is 99, I will award everyone who takes this exam an extra point; thus the maximum number of points on this exam is 100. 🙂

Regarding content, the exam is all about  arbitrage-free pricing of forwards and options.

I will look forward to seeing all of you at the exam tomorrow. Good luck!

Office Hours

Hi, I am Alexander Law, your graduate assistant for the Spring 2018 semester.

In light of your upcoming exam, I will be hosting office hours from 7-11pm tonight at the Financial Markets Center, Room 116 of the Business School.

You can also email me at Alexander_Law@baylor.edu

Thank you for your time and considerations.

Era of Calm Ends as Volatility Returns to Markets

With the return of volatility in stocks, those investors and trades that profit when markets are calm are suffering heavy losses.
The above referenced WSJ article (published yesterday) tells a very interesting story about volatility as an asset class. VIX exchange-traded products (such as Credit Suisse’s now infamous and soon-to-become-defunct) VelocityShares Daily Inverse VIX Short-Term exchange-traded note (XIV)) were originally conceived of in the aftermath of the global financial crisis as a form of insurance against against increases in market volatility.
As we have previously discussed (see “On the relationship between the S&P 500 and the CBOE Volatility Index (VIX)“), returns on the S&P 500 stock market index and VIX tend to be strongly negatively correlated with each other.  Thus, VIX exchange-traded products such as XIV offer investors the opportunity to hedge against increases in volatility.  Indeed, by reversing the letters in the VIX ticker symbol, the VelocityShares Daily Inverse VIX Short-Term exchange-traded note in particular effectively branded itself as a financial product which hedges volatility.  However, as market volatility subsided during recent months and years, many investors began to sell rather than buy products such as XIV in hopes of boosting portfolio returns.  With stocks trading at historically low volatility levels lately, this strategy seemed to be working pretty well for many investors; that is, until this past week when volatility made its comeback:
The next graph shows the time series for daily closing prices on XIV and on VIX, from 11/30/2010 (which is the first day for which daily data for XIV are available) through yesterday (2/6/2018):
 Within this date range, the correlation between XIV and VIX is -.5608.  Of course, the most interesting aspect of this graph corresponds to the enormous drop in XIV from its all-time closing high of 144.75 (on January 12, 2018) to 7.35 at the close yesterday.  On the same day that XIV reached its all-time closing high,  VIX closed at 10.16, but stood at 37.32 at the close on Monday, February 5.

A Random Walk Down Wall Street

In my opinion, if you were to read only one book about finance, it would have to be “A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing” by Burton G. Malkiel. Malkiel’s book (now in its 11th edition) provides a compelling argument in favor of efficient markets theory and investing in (passively managed) index funds.

Efficient market theory implies that stock prices follow a random walk. These ideas were originally conceived of by Professors Paul Samuelson and Eugene Fama in the 1960’s, and subsequently popularized by folks like Professor Malkiel. In Finance 4366, we rely extensively upon the notion that prices of speculative assets (e.g., stocks, bonds, commodities, foreign exchange, etc.) follow random walks as we consider the technical details associated with pricing and hedging risk using financial derivatives.

Finance 4366