QUESTION SIX a). When investment managers present their historical performance r

Question

QUESTION SIX

a). When investment managers present their historical performance records to prospective and existing customers /investors, market regulators require the managers to qualify those records with the comment that “past performance is no guarantee of future performance.” In an efficient market, why would such admonition be particularly appropriate? (6 marks)

b). Does the fact that the market exhibits a weak form of efficiency necessarily imply that it is also strong form efficient? How about the converse statement? Explain. (6 marks)

c). If the premium on a call option has recently declined, does this decline indicate that the option is a better buy than it was before? Why or why not? (3 marks)

d). List the five variables needed to estimate the value of a call option. Describe how a change in each of these variables affects the value of a call option. (10 marks)

Explanation / Answer

(a) Effiecient Markets which are described under the Efficient Market Hypothesis state that "efficiency" of the stock markets result in existing stock prices incorporating and reflecting all relevant information almost instantaneously. Consequently, it is impossible to identify and purchase undervalued stocks (or sell overvalued stocks) using either fundamental analysis or technical analysis for stock selection. In other words it is not possible for investors to "beat the market" as all stocks trade at their respective fair values (with all relevant information factored in). The only possible way to earn higher returns would then be to invest in riskier assets. Since, efficient markets incporporate all relevant information, any repetition of a historical event that wou;d have previously effected prices will result in their (the repeated event) impact on stock prices being already "factored in". Therefore, one cannot expect repetition of the impact of the historical event and consequently the repetition of historical prices.

(b) Weak form effiecient implies that futue prices cannot be predicted using historical price trends and hence Technical Analysis for price prediction will not work. However, weak form efficient markets do not imply an unbiased and immediate incoporation of relevant information into existing stock prices. This provides a room for using fundamental analysis to indulge in "expert stock selection".

Strong form  efficient implies that markets incorporate all types information, historical price trends and more almost instantaneously, thereby making both fundamental and technical analysis worthless. Theoretically, no one can beat the market in a strongly efficient setup.

Therefore, weak form efficient does NOT imply strongly efficient but the converse is necessarily true.

(c) Premium on a call option is the price an investor pays to be able to gain the right but not obligation of exercising the call option in the furture. A call option is an option that allows purchase of the underlying asset at a fixed price (called strike price) in the future. Quite, logically an investor will exercise the option in future only if the spot price of the underlying asset goes above the strike price. The investor will buy the asset at the strike price and sell it further at the existing higher spot price to earn a neat profit. The investor's initial payment of the call premium will be his/her initial investment. In such a scenario if underlying asset spot price is expected to rise above the strike price in future, then call premiums will surely rise (as the investor will have a sure shot at making a profit). In case call premiums fall, it implies that there are slim chances of the future spot price breaching the strike price. Hence, buying a call option in that scenario would not be advisable.

(4) Factors impacting valuation of a call option would be Underlying Asset Price, Strike Price, Time to maturity, Volaitility of the underlying asset's price and interest rates.

Underlying asset price has a direct relation with call option price. If asset prices go up call option prices go up and vice-versa. This is because rising prices indicate an easy breach of the strike price, thereby making the call option buyer a profit.

Strike Price has inverse relation with call option price, as a high strike price would make it diffcult for the underlying spot price to breach it and make profit for the investor. A low strike price is easily breachable and hence easier to make a profit in. Therefore, low strike prices options are more in demand and have higher prices.

Time to maturity is directly related to the call option price which means that longer the time to maturity, higher is the option price. This is because the longer the time taken to reach maturity higher are the chances of the call option ending up being "in the money" (Future Spot Price > Strike Price).

Volaitility of the Underlying Asset is directly related to call option price. This happens because higher the volaitility higher is expected price fluctuations in either direction (upward or downward). Although downward price movement is undesirable, the opposite is highly coveted in the expectation of the price breaching the strike price and making money for the call option holder.

Interest rates have a direct relationship with call option prices i.e rising interest rates lead to rise in call option prices due to cost of holding the call option. If the money used to pruchase the option is borrowed then the pruchaser faces higher interest expense and if own funds are used then he/she faces higher lost interest income.

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