2.6 Foundations of Financial Economics

Question 1

CAPM

Answer 1

• single risk factor asset pricing model —> market risk factor E(Ri) = Rf + β[E(Rm) - Rf] - asserts that expected return on an asset is determined by its systematic risk (beta) -asserts that no additional return will be earned by bearing non-systematic (idiosyncratic, or investment specific) risks

Question 2

Ex-post CAPM

Answer 2

Ri,t - Rf = β(Rm,t - Rf) + εi,t Where εi,t is the unexplained return due to idiosyncratic risk at time t

Question 3

Fama-French 3 Factor Empirical Model

Answer 3

• 3 factors: market beta, market capitalization, book to market ratio E(Ri) - Rf = β1(Rm - Rf) + β2E(SMB) + β3E(HML) SMB —> small minus big HML —> high minus low

Question 4

Fama-French 4 factor model

Answer 4

Add +β4E(UMD) UMD —> up minus down, or momentum factor

Question 5

Commodity Cost of Carry

Answer 5

• cost in holding asset until expiration of the forward contract F(T) = S + carrying costs

Question 6

Financial Forwards Cost of Carry

Answer 6

• have costs for financing, coupon payments or dividends ** forward contracts on financial assets do not entitle the holder to dividends or coupons F(T) = S * e^((r - d) * T) or S = F(T) * e^(-(r - d) * T)

Question 7

Binomial call option price

Answer 7

C/S = Cu / Su C= Option price today S= stock price in time zero Cu= option price upper node Su= stock price upper node

Question 8

Four Cost of Carry models for financial securities

Answer 8

1. No interest and no dividends - simplifies to F(T) = S 2. Interest rate equals dividend rate - r - d equals 0 - F(T) = S 3. Interest rate greater than dividend rate (r>d) - forward price must exceed the spot price - term structure upward sloping 4. Dividend rate greater than interest rate - forward price is less than the spot price - dividends and distributions lower the value of the security in the spot market

Question 9

Options structure

Answer 9

C. P L _____/ _______ S. ——-. /———- Time ————->————->

Question 10

Long Call

Answer 10

• own the right to buy - for strike price x

Question 11

Long Put

Answer 11

Question 12

Short Call

Answer 12

Question 13

Short Put

Answer 13

Question 14

Straddle and Strangle

Answer 14

Question 15

Covered Call and Protective Put

Answer 15

Question 16

Bull and Bear Spread

Answer 16

Question 17

Risk Reversal

Answer 17

Question 18

Put Call Parity

Answer 18

call - put + bond = underlying asset C - P + Pv(x) = S

Question 19

Option Greeks

Answer 19

S is asset price —> delta = sensitivity to change in price of underlying security σs is volatility of the asset —-> Vega = sensitivity of the option price to changes in price volatility (think ‘v’ for volatility) Rf is risk free interest rate —-> Rho = sensitivity of option price to changes in risk free rate T is time to expiration —-> theta = sensitivity of option price to changes in time to expiration Gamma = rate of change in delta compared to changes in price of underlying security